Purchasing-Power Parity and Exchange Rates

In the short run, market-determined exchange rates are highly volatile in response to monetary policy, political ~ents, and changes in expectations. But over the longer run, exchange rates are determined primari.1y by the relative prices of goods in-different countries. An important implication is the purchasing potter parity (PPP) theory of exchan~ rain. Under this theory, a nation’s exchange -rate will tend to equalize the cost -of buying traded goods at home with the cost of buying those goods abroad.

We should caution that the PPP theory IS only an approximation and cannot predict the precise movement of exchange rates. The leeway in the PPP theory is.seen in the relationship between die U.S. . dollar and the Japanese yen over the last decade this’ exchange ‘rate has been as high as 168 yen to a dollar and as low as 85 yen to a dollar, even though mos~ ‘economists calculate the PPP level as being 120 yen to a dollar. Trade barriers, transportation costs, and the presence of non traded services allow prices to diverge significantly across Council tries. In addition, financial flows. can overwhelm : trade flows in the short run. So while the PPP theory is a useful guide to exchange rates in the 10 run, exchange rates can diverge from their PPP I for many years.

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