International Finance

Topics: Foreign exchange market, Inflation, Exchange rate, Purchasing power parity / Pages: 42 (10267 words) / Published: Feb 28th, 2013
In H. Kent Baker and Leigh A. Riddick (eds.) Survey of International Finance, Oxford University Press, 2012

2
A Primer on Exchange Rate Behavior
JAMES R. LOTHIAN

Distinguished Professor of Finance, Fordham University
M A R K P. T A Y L O R

Dean, Warwick Business School; Professor of Finance, University of Warwick

Introduction
An exchange rate is the relative price of one country’s money in terms of another. What is being exchanged as money has varied over time with the particular assets that served as monies. For most of recorded history up until the early part of the last century, money generally consisted of a metallic coinage of one sort or another. Since then money has come increasingly to consist of currency notes and, more importantly, bank deposits. Economists’ key insight with regard to exchange rate behavior centers on the concept of purchasing power parity (PPP). Stated simply, the PPP exchange rate is the nominal exchange rate that equates the purchasing power of a unit of currency in the foreign economy and the domestic economy. So, for example, suppose the PPP exchange rate between the U.S. dollar and the British pound sterling is two dollars ($) per pound (£). Then, if the exchange rate that actually prevails in the market also is two dollars per pound, the same basket of goods that can be bought for $100 in the United States can be bought for £50 in the United Kingdom. Over the past several decades the literature investigating PPP has become voluminous, according to one set of estimates growing at an average rate of 15 percent per annum over the period 1974 to 2003 (Clements and Lan 2004). The upshot of these studies is that over long periods, and for countries that have substantial differences in price-level behavior, the PPP hypothesis provides a tolerably good fi rst approximation to actual behavior. The fourth section of this chapter reviews the major empirical fi ndings from the literature supporting that interpretation. The

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