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What does the theory of purchasing-power parity say about exchange rates? It tells us that the nominal exchange rate between the currencies of two countries depends on the price levels in those countries. If a dollar buys the same quantity of goods in the United States (where prices are measured in dollars) as in Japan (where prices are measured in yen), then the number of yen per dollar must reflect the prices of goods in the United States and Japan. For”example, if a pound of coffee costs 500 yen in Japan and $5 in the United States, then the nominal exchange rate must be 100 yen per dollar (500 yen/$5 =’ 100 yen per dollar). Otherwise, the purchasing power of the dollar would not be the same in the two countries.

To see more fully how this works, it is helpful to use just a bit of mathematics. Suppose that P is the price of a basket of goods in the United States (measured in dollars), p. is the price of a basket of goods in Japan (measured in yen), and e is the nominal exchange rate (the number of yen a dollar can buy). Now consider the quantity of goods a dollar can buy at home and abroad. At home, the price level is P, so the purchasing power of $1 at home is lP. That is, a dollar can buy lP quantity of goods. Abroad, a dollar can be exchanged into e units of foreign currency, which in turn have purchasing power eP. For the purchasing power of a dollar to be the same in the two countries.

Notice that the left side of this equation is a constant, and the right side is the real exchange rate. Thus, if the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate the relative price o/domestic and foreign goods-cannot change.

To see the implication of this analysis, for the nominal exchange can rearrange the last equation to solve for the nominal exchange rate.

That is, the nominal exchange rate equals the ratio of the foreign price level (measured in units of the foreign currency) to the domestic price level (measured in units of the domestic currency). According to the theory of purchasing-power parity, the nominal exchange rate between the currencies of two countries must reflect the price levels in those countries.

A key implication of this theory is that nominal exchange rates change when price levels change. As we saw in the preceding chapter, the price level in any country adjusts to bring the quantity of money supplied and the quantity of money demanded into balance. Because the nominal exchange rate depends on the price levels, it also depends on the money supply and money demand in each country. When a central bank in any country increases the money supply and causes the price level to rise, it also causes that country’s
currency to depreciate relative to other currencies in the world. In other words, when the central bank prints large quantities of money, that money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.

We can now answer the question that began this section: Why did the US. dollar lose value compared to the German mark and gain value compared to the Italian lira? The answer is that Germany pursued a less inflationary monetary policy than the United States, and Italy pursued a more inflationary monetary policy. From 1970 to 1998, inflation iri the United States was 5.3 percent per year. By contrast, inflation was 3.5 percent in Germany and 9.6 percent in Italy. As US. prices rose relative to German prices, the value of the dollar fell relative to the mark. Similarly, as US. prices fell relative to Italian prices, the value of the dollar rose relative to the lira.

Germany and Italy now have a common currency-the euro. This means that the two countries share a single monetary policy and that the inflation rates in the two countries will be closely linked. But the historical lessons of the lira and the mark will apply to the euro as well. Whether the US. dollar buys more or fewer euros 20 years from now than it does today depends on whether the European Central Bank produces more or less inflation in Europe than the Federal Reserve does in the United States.

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