understand why in the long run under a fixed exchange rate system a country's monetary policy and thus inflation rate are forced to be the same as that of the rest of the world;
know how to use the purchasing power parity rule of thumb to predict what will be happening to the exchange rate in the long run in an inflationary environment under a flexible exchange rate system; and
be able to calculate the purchasing power parity exchange rate and explain why it is used to calculate standard-of-living comparisons between countries.
17.1 Inflation With a Fixed Exchange Rate
In chapter 15 we saw that a rise in our price level, with no corresponding rise in foreign prices, leads to a balance of payments deficit, which under a fixed exchange rate system in turn leads to an automatic contraction of our money supply. The same will happen if the rate of inflation in cur economy is greater than the rate of inflation in the rest of the world.
Suppose U.S. inflation is 8 percent, but it is only 5 percent in the rest of the world, due to differing money-supply growth rates. With a fixed exchange rate, during the first year U.S. prices rise by 3 percent more than foreign prices. If nothing changes, during the following year the gap between U.S. and foreign prices widens by another 3 percent, and so on, year after year. It is not true, however, that nothing changes.
Prices in the United States are rising relative to foreign prices, so U.S. exports should fall and imports should rise. As a result, the United States should develop a balance of payments deficit, and the rest of the world should develop a balance of payments surplus. Under fixed exchange rates these developments should automatically decrease the U.S. money supply and automatically increase the foreign money supply. The fall in money-supply growth in the United States lowers its rate of inflation over the long run, and the increase in money-supply growth in the rest of the world increases foreign inflation over the long run. The pressure on both inflation rates continues as long as the U.S. inflation rate exceeds that of the rest of the world. Eventually, inflation and money-supply growth in the rest of the world should match those of the United States.
Does inflation in the rest of the world rise to match American inflation? Does American inflation fall to match foreign inflation? Or do they both move to an intermediate rate? From 1945 to 1971 when most countries were on a fixed exchange rate system, the Bretton Woods system, all countries fixed their exchange rates relative to the U.S. dollar so that in
