The advent of floating exchange rates and the substantial changes in relative prices and exchange rates in recent years have renewed interest in the purchasing-power-parity (PPP) theory of the exchange rate. Its main tenet is that, with some caveats, the equilibrium exchange rate is determined by the PPP relationship and that, if left to float freely, the exchange rate will tend to the PPP equilibrium. This paper addresses itself to the disequilibrium theory implied by the PPP theory. What can be said about the disequilibrium in periods that are too short to allow full exchange rate adjustment, or during which the monetary authorities intervene in exchange markets to maintain the exchange rate at disequilibrium levels? In particular, what is the relationship between disequilibrium in the exchange rate and disequilibrium in the balance of payments accounts?
This paper attempts to find evidence for the hypothesis that a country with an overvalued (undervalued) currency will tend to find itself in balance of payments deficit (surplus). This hypothesis is tested by constructing a relative price index (RPI) that may be used to judge the relative overvaluation or undervaluation of 14 industrial countries for the period 1963:111 to 1974: IV. Section I provides some historical background by presenting the movements of a measure of the RPI for the period 1963:1 to 1976:1. One of the more controversial issues in the literature of the PPP theory is the question of the appropriate RPI. Section II touches upon this issue and provides the theoretical background for a relationship between the RPI and the balance of payments accounts. Section III tests a specific functional form of the above hypothesis and presents the results for eight alternative measures of the RPI. Section IV presents a summary and the conclusions of the paper. The Appendix details the data sources and transformations used in this paper.
This Appendix contains the data transformations and the data sources used. All indices have the year 1970 as the base period.
Cassel, Gustav (1925), “Rates of Exchange and Purchasing-Power Parity,” Skandinaviska Kreditaktiebolaget, Quarterly Report (April 1925), pp. 17–21.
Frenkel, Jacob A., “A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence,” Scandinavian Journal of Economics, Vol. 78 (No. 2, 1975), pp. 200–24.
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Mr. Brillembourg, economist in the Special Studies Division of the Research Department, is a graduate of Harvard University and of the University of Chicago.
For some countries, the data for 1976:1 is based on Fund staff estimates of the price indices.
For reference on the doctrinal history of PPP, see Frenkel (1976) and Officer (1975).
See Rhomberg (1975).
Depending on the approach taken, this standardization takes into account either the different sizes of countries’ trade sectors (the United States being an outlier because of the relatively small size of its trade sector) or, in an asset approach, the different sizes of countries’ asset portfolios.
This procedure, in effect, constrains the income elasticity to be one. This constraint is imposed for the sake of maintaining a simple hypothesis and a reasonable approximation of the true elasticity.
This procedure again constrains the elasticities of the domestic and foreign cycles to be of the same magnitude but opposite in sign. Aside from simplifying the hypothesis, it avoids the problems owing to the high correlation between the two measurements of the business cycle. The alternative specification of including the rest of the world’s business cycle index separately was also tried, but was not reported since the results were very similar to those reported above; only Denmark and Canada have their lag distribution affected.
See Griliches (1967). By introducing both the current and the lagged independent variables, the lag structure of the RPI can be made quite dissimilar to that of the RCY; in particular, the average lags need not be equal. Nevertheless, a caveat is in order. While this formulation goes part way in estimating separate lag structures for the two independent variables, the two lag structures are related, and, consequently, biases may be introduced in the estimated lag structures if the true lag structures are very dissimilar.
The balance of payments is redefined so that it is in equilibrium when the RPI and RCY are zero—that is, when BP* is equal to BP less b0. This redefinition is necessary only because the base year for the indices was chosen without regard to the balance of payments equilibrium.