500 PA R T V I FYI International Finance and Monetary Policy The Purchasing Power Parity Puzzle The theory of purchasing power parity has attracted a great deal of attention and has been explored extensively in the recent literature using recent advances in the field of applied econometrics Based on the law of one price, the theory asserts that relative goods prices are not affected by exchange rates or, equivalently, that exchange rate changes will be proportional to relative inflation The relationship is important not only because it has been a cornerstone of exchange rate models in international economics, but also because of its policy implications it provides a benchmark exchange rate and therefore has some practical appeal for policymakers and exchange rate arbitragers Empirical studies generally fail to find support for long-run purchasing power parity, especially during the recent floating exchange rate period In fact, the empirical consensus is that purchasing power parity does not hold over this period But there are also studies covering different groups of countries as well as studies covering periods of long duration or country pairs experiencing large differentials in price movements that report evidence consistent with the theory of purchasing power parity For an excellent discussion of the purchasing power parity puzzle, see Kenneth Rogoff, The Purchasing Power Parity Puzzle, Journal of Economic Literature 34 (1996): 647 668 Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates The PPP conclusion that exchange rates are determined solely by changes in relative price levels rests on the assumption that all goods are identical in both countries and that transportation costs and trade barriers are very low When this assumption is true, the law of one price states that the relative prices of all these goods (that is, the relative price level between the two countries) will determine the exchange rate The assumption that goods are identical may not be too unreasonable for Canadian and Japanese steel, but is it a reasonable assumption for Canadian and Japanese cars? Is a Toyota the equivalent of a Chevrolet? Because Toyotas and Chevys are obviously not identical, their prices not have to be equal Toyotas might be more expensive relative to Chevys and both Canadians and Japanese will still purchase Toyotas Because the law of one price does not hold for all goods, a rise in the price of Toyotas relative to Chevys will not necessarily mean that the yen must depreciate by the amount of the relative price increase of Toyotas over Chevys PPP theory furthermore does not take into account that many goods and services (whose prices are included in a measure of a country s price level) are not traded across borders Housing, land, and services such as restaurant meals, haircuts, and golf lessons are not traded goods So even though the prices of these items might rise and lead to a higher price level relative to another country s, there would be little direct effect on the exchange rate Factors That Affect Exchange Rates in the Long Run Our analysis indicates that in the long run, four major factors affect the exchange rate: relative price levels, trade barriers, preferences for domestic versus foreign goods, and productivity We examine how each of these factors affects the exchange rate while holding the others constant