International macroe.. - Free

Chapter 7The Real Exchange RateIn this chapter, we examine the behavior of the nominal exchange ratein relation to domestic and foreign goods prices in the short run andin the long run. A basic theoretical framework that underlies the empiricalexamination of these prices is the PPP doctrine encountered inchapter 3. The ßexible price models of chapters 3 through 5 assumethat the the law-of-one price holds internationally, and by implication,that purchasing-power parity holds. In empirical work, we deÞne the(log) real exchange rate between two countries as the relative pricebetween a domestic and foreign commodity basketq = s + p ∗ − p. (7.1)Under purchasing-power parity, the log real exchange rate is constant(speciÞcally, q =0).The prediction that q t is constant is clearly false–a fact we discoveredafter examining Figures 3.1 in chapter 3.1. This result is not new.So given the obvious short-run violations of PPP, the interesting thingsto study are whether these international pricing relationships hold inthe long run, and if so, to see how much time it takes to get to thelong-run.Why would we want to know this? Because real exchange rateßuctuations can have important allocative effects. A prolonged realappreciation may have an adverse effect on a country’s competitivenessas the appreciation raises the relative price of home goods and induces207