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The Long-Term Behaviour of Exchange Rates, Part I: Introduction

Listed author(s):
  • Yihui Lan

    (UWA Business School, The University of Western Australia)

Registered author(s):

    In 1972, just prior to the collapse of the Bretton-Woods system of fixed exchange rates, the US dollar cost about .4 British pounds. By 1985, the dollar had appreciated to .9 pounds, but by 2001 it had fallen back to about .7 pounds. Such substantial changes in currency values over the longer term are commonplace in a world of floating exchange rates. The thesis aims to enhance understanding of such long-term movements in exchange rates by focusing on one of the central pillars of international economics, purchasing power parity (PPP) theory. This provides the fundamental link between exchange rates and prices, and is the theoretical foundation underlying many exchange-rate models. We present an extensive review of PPP theory and highlight the role of real factors such as international productivity differences in determining exchange rates over the longer term. We also demonstrate that PPP is one of the most rapidly expanding areas of research in economics, and present an analytical overview of the PPP literature. The Big Mac Index, invented by The Economist magazine in 1986, has played a major role in popularising PPP and bringing its practical implications to the attention of financial markets in particular. This thesis tests for PPP using the Big Mac data. We use enhanced econometric procedures that deal with problems of bias and estimation uncertainty associated with a small sample. The test results not only favour PPP, but also suggest a shorter half-life of deviations from parity than that previously reported in much of the literature. As PPP holds, there exists a long-run equilibrium value to which the actual exchange rate reverts, which we identify with the “equilibrium exchange rate” (EER). We introduce a new methodology based on Monte Carlo techniques to estimate the whole distribution of the EER and the adjustment path of the actual rate into the future. This new approach seems to have a number of attractive features including its modest data requirements (exchange rates and Big Mac prices), the minimal economic structure placed on the problem and its simplicity. Interestingly, our estimates of EERs are quite close to those of other studies using more complex methodologies.

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    File URL: http://ecompapers.biz.uwa.edu.au/paper/PDF%20of%20Discussion%20Papers/2003/03_05_Lan.pdf
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    Paper provided by The University of Western Australia, Department of Economics in its series Economics Discussion / Working Papers with number 03-05.

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    Length: 36 pages
    Date of creation: 2003
    Handle: RePEc:uwa:wpaper:03-05
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    Web page: http://www.business.uwa.edu.au/school/disciplines/economics

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    1. Martin D. D. Evans & Richard K. Lyons, 2002. "Order Flow and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 110(1), pages 170-180, February.
    2. Li Lian Ong & Jason Mitchell, 2000. "Professors and hamburgers: an international comparison of real academic salaries," Applied Economics, Taylor & Francis Journals, vol. 32(7), pages 869-876.
    3. Annaert, Jan & De Ceuster, Marc J. K., 1997. "The Big Mac: More than a junk asset allocator?," International Review of Financial Analysis, Elsevier, vol. 6(3), pages 179-192.
    4. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-660, June.
    5. Michael R. Pakko & Patricia S. Pollard, 1996. "For here or to go? Purchasing power parity and the Big Mac," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 3-22.
    6. Koedijk, Kees G. & Schotman, Peter, 1990. "How to beat the random walk : An empirical model of real exchange rates," Journal of International Economics, Elsevier, vol. 29(3-4), pages 311-332, November.
    7. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
    8. MacDonald, Ronald & Taylor, Mark P., 1994. "The monetary model of the exchange rate: long-run relationships, short-run dynamics and how to beat a random walk," Journal of International Money and Finance, Elsevier, vol. 13(3), pages 276-290, June.
    9. MacDonald, Ronald, 1983. "Some Tests of the Rational Expectations Hypothesis in the Foreign Exchange Market," Scottish Journal of Political Economy, Scottish Economic Society, vol. 30(3), pages 235-250, November.
    10. Robert E. Cumby, 1996. "Forecasting Exchange Rates and Relative Prices with the Hamburger Standard: Is What You Want What You Get With McParity?," NBER Working Papers 5675, National Bureau of Economic Research, Inc.
    11. Frankel, Jeffrey A. & Rose, Andrew K., 1995. "Empirical research on nominal exchange rates," Handbook of International Economics,in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 33, pages 1689-1729 Elsevier.
    12. Ong, Li Lian, 1997. "Burgernomics: the economics of the Big Mac standard," Journal of International Money and Finance, Elsevier, vol. 16(6), pages 865-878, December.
    13. Click, Reid W., 1996. "Contrarian MacParity," Economics Letters, Elsevier, vol. 53(2), pages 209-212, November.
    14. Mark P. Taylor, 2003. "Purchasing Power Parity," Review of International Economics, Wiley Blackwell, vol. 11(3), pages 436-452, 08.
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