Relative Prices and Floating Exchange Rates-an Empirical Exploration

The question whether changes in relative prices can affect exchange rates would be easy to answer if certain popular theories were valid. According to simple monetarism, for instance, the exchange rate between two currencies depends only on the money supply in the respective countries; the impact of relative price changes can hence be at most indirect, and these changes will contribute nothing to the explanation of actual exchange rates if monetary factors are also taken into account. Similarly, adherents of Purchasing Power Parity (PPP)-who may or may not be simple monetarists-hold that only the general price level, and not relative prices, matter. The Keynesian ‘absorption’ approach, which is not as popular as it once was, attributes central importance to income changes and gives little or no weight to changes in relative prices.