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The Collapse of Purchasing Power Parities during the 1970s

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  • Jacob A. Frenkel

Abstract

This paper reviews and analyzes the empirical record of exchange rates and prices during the 1970's and the analysis is based on the experience of the Dollar/Pound, the Dollar/French Franc and the Dollar/DM exchange rates. Section 2 presents the evidence on PPP during the 1970's and contrasts it with the evidence from the 1920's -- a period during which the doctrine held up reasonably well. This analysis is relevant for assessing whether the flexible exchange rate system was successful in providing national economies with an added degree of insulation from foreign shocks, and whether it provided policymakers with an added instrument for the conduct of macroeconomic policy. The evidence regarding deviations from purchasing power parities is also relevant for determining whether there is a case for managed float. Section 3 attempts to explain what went wrong with the performance of the doctrine during the 1970's. It examines the hypothesis that the departures from PPP are a U.S. phenomenon, as well as the hypothesis that the departures are due to large changes in inter-sectoral relative price changes within the various economies. Given that the predictions of the simple versions of PPP do not hold up, section 4 proceeds in examining the question of whether national price levels have been independent of each other. Section 5 addresses the question of whether exchange rates and national price levels are comparable and whether in principle one should have expected them to be closely linked to each other. The main point that is being emphasized is that there is an important intrinsic difference between exchange rates and national price levels which stems from the basset market theory' of exchange rate determination. This theory implies that the exchange rate, like the prices of other assets, is much more sensitive to expectations concerning future events than national price levels and as a result, in periods which are dominated by news' which alter expectations, exchange rates are likely to be much more volatile than national price levels and departures from PPP are likely to be the rule rather than the exception. Finally, section 6 concludes the paper with some policy implications.

Suggested Citation

  • Jacob A. Frenkel, 1980. "The Collapse of Purchasing Power Parities during the 1970s," NBER Working Papers 0569, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:0569
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    1. Frenkel, Jacob A & Mussa, Michael L, 1980. "The Efficiency of Foreign Exchange Markets and Measures of Turbulence," American Economic Review, American Economic Association, vol. 70(2), pages 374-381, May.
    2. Gordon, Robert J., 1976. "Recent developments in the theory of inflation and unemployment," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 185-219, April.
    3. Brunner, Karl & Meltzer, Allan H., 1976. "Institutional arrangements and the inflation problem," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 3(1), pages 1-13, January.
    4. Rudiger Dornbusch, 1979. "Monetary Policy Under Exchange Rate Flexibility," NBER Working Papers 0311, National Bureau of Economic Research, Inc.
    5. Brunner, Karl & Meltzer, Allan H., 1979. "Policies for employment, prices, and exchange rates," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 11(1), pages 1-7, January.
    6. Lawrence H. Officer, 1982. "The Purchasing-Power-Parity Theory of Gerrard de Malynes," History of Political Economy, Duke University Press, vol. 14(2), pages 256-259, Summer.
    7. Jacob A. Frenkel & Michael L. Mussa, 1980. "Efficiency of Foreign Exchange Markets and Measures of Turbulence," NBER Working Papers 0476, National Bureau of Economic Research, Inc.
    8. Mussa, Michael, 1976. "Our recent experience with fixed and flexible exchange rates: A comment," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 3(1), pages 123-141, January.
    9. Mussa, Michael, 1979. "Empirical regularities in the behavior of exchange rates and theories of the foreign exchange market," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 11(1), pages 9-57, January.
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    Cited by:

    1. Macchiarelli, Corrado, 2014. "Bond market co-movements, expected inflation and the GBP-USD equilibrium real exchange rate," The Quarterly Review of Economics and Finance, Elsevier, vol. 54(2), pages 242-256.
    2. Mark Holmes & Jesús Otero & Theodore Panagiotidis, 2012. "PPP in OECD Countries: An Analysis of Real Exchange Rate Stationarity, Cross-Sectional Dependency and Structural Breaks," Open Economies Review, Springer, vol. 23(5), pages 767-783, November.
    3. Han, Bing & Hirshleifer, David & Wang, Tracy Yue, 2005. "Investor Overconfidence and the Forward Discount Puzzle," Working Paper Series 2005-21, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    4. Carlos Eduardo Castillo-Maldonado & Fidel Pérez-Macal, 2013. "Assessment of models to forecast exchange rates: The quetzal–U.S. dollar exchange rate," Journal of Applied Economics, Universidad del CEMA, vol. 16, pages 71-99, May.
    5. Marcos José Dal Bianco, 2008. "Argentinean real exchange rate 1900-2006, test purchasing power parity theory," Estudios de Economia, University of Chile, Department of Economics, vol. 35(1 Year 20), pages 33-64, June.
    6. Martins Bitans, 2004. "Pass-Through of Exchange Rates to Domestic Prices in East European Countries and the Role of Economic Enviroment," Working Papers 2004/04, Latvijas Banka.

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