THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES

Exchange rates vary substantially over tune. In 1970, a U.S. dollar could be used to buy 3.65 German marks or 627 Italian lira. In 1998, as both Germany and Italy were getting ready to adopt the euro as their common currency. dollar bought 1.76 German marks or 1,737 Italian lira. In other words, over this period, the value of dollar fell by more than half compared to the mark, while it more than doubled compared to the lira.

What explains these large and opposite changes? Economists have developed many models to explain how exchange rates are determined, each emphasizing just some of the many forces at work. Here we develop the simplest theory of exchange rates, called purchasing-power parity. This theory states that a unit of any given currency should be able to buy the same quantity of goods in all countries. Many economists believe that purchasing power parity describes the forces that determine exchange rate s in the long run. We now consider the logic on which this long-run theory of exchange rates is based, as well as the theory’s implications and limitations.