2 management - School of International Business and ...

Günter S. Heiduk
founded exchange rate and the macroeconomic aggregate of the balance of payments is on the
top of political and academic controversies, e.g. the Renminbi – US Dollar discussion.
Figure 13 | USD/Euro, 1 hour interval, 26 Sept. – 02 Oct. 2012
Source: www.dailyfx.com
Exchange rate theories can be classified into three different types [Kanamori/Zhao, 2006]
– partial equilibrium models which cover the goods markets (Purchasing Power Theory), the
asset markets (Interest Rate Theory) or the balance of payments,
– general exchange rate equilibrium models (Mundell-Fleming Model) which include goods
and assets markets as well as the balance of payments,
– monetary models (e.g. Dornbusch Model) which combine the monetary equilibrium with
the adjustment of price and output toward their long-run equilibrium.
In the following only the most popular Purchasing Power Theory will be discussed in detail. Accord-
ing to the »law of one price«the price of one good should be equal at home and abroad. Under the
condition that firstly the prices of each good are equalized between the two countries and secondly
the goods baskets and their weights in these countries are the same, the absolute purchasing
power parity determines the long-run macroeconomic equilibrium. The exchange rate equals the
relation between the domestic and foreign price level: w = PI / PII or PI = w . PII.
The absolute PPP implies that the real exchange rate does not change over time. In order to mit-
igate this restriction the equation can be modified by transforming the absolute PPP into rates of
PPP changes. Then, the relative change of the exchange equals the difference of the inflation rates
between the two countries.
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