Figure 17.1 Resolving Inflation Differences Under a fixed exchange rate a small foreign country is forced to experience the monetary policy and inflation of the United States, and under a flexible exchange rate the exchange rate adjusts continually to offset the inflation differential.
17.3 Purchasing Power Parity
Like the formula for inflation from chapter 9, the PPP relationship is best described as a rule of thumb for predicting long-run behavior. In the short run, exchange rate changes are very volatile, affected by political events, business cycles, speculator activity, monetary policies, and rumors affecting financial markets, among many other things. Consequently, PPP is unlikely in the short run to be a good guide to exchange rate behavior.
Even in the long run, PPP can be a poor guide because it ignores a variety of factors that permanently influence our ability to compete on international markets:
1. Natural resource discoveries such as Alaska or North Sea oil.
2. Invention of new products such as VCRs.
3. Changes in barriers to trade such as tariff reductions associated with free trade agreements.
4. Changes in consumers' tastes for imported versus domestic goods.
5. Permanent changes in countries' relative real interest rates.
6. Differing rates of productivity growth across countries.
7. Overall inflation rates not accurately reflecting price changes in traded goods and services.
All the factors listed above can permanently affect the exchange rate in the long run in the absence of inflation, thus invalidating the PPP result and marking a difference between the real and nominal exchange rates. This difference is illustrated in figure 17.2. A large swing in the real U.S. exchange rate occurred during the 1980s as the result of a high relative U.S. real