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210 CHAPTER 7. THE REAL EXCHANGE RATEdollar price of German exports of these items to the dollar price of USexports of the same items. Between 1970 and 1975, the dollar fell by55.2 percent while at the same time the relative export price of internalcombustion engines, office calculating machinery, and forklift trucksincreased by 48.1 percent, 47.7 percent, and 39.1 percent, respectivelyin spite of the fact that German and US prices are both measured indollars. Evidently, nominal exchange rate changes over this Þve-yearperiod had a big effect on the real exchange rate.In a separate regression analysis, he obtains 7-digit export commoditieswhich he matches to 7-digit import unit values in which theimports are distinguished by country of origin. The dependent variableis the US import unit value from Canada, Japan, and Germany, respectively,divided by the unit values of US exports to the rest of the world,both measured in dollars. If the law-of-one price held, this ratio wouldbe 1. Instead, when the ratio is regressed on the DM price of the dollar,the slope coefficient is positive but is signiÞcantly different from 1 forGermany and Japan. The slope coefficients and implied standard errorsfor Germany and Japan are reproduced in Table 7.1. 1 The estimatesfor Germany indicate that import and export prices exhibit insufficientdependence on the exchange rate to be consistent with the law-of-oneprice, whereas the estimates for Japan suggest that there is too muchdependence.While Isard’s study provides evidence of striking violations of thelaw-of-one price, it is important to bear in mind that these results weredrawn from a very short time-series sample taken from the 1970s. Thiswas a time period of substantial international macroeconomic uncertaintyand one in which people may have been relatively unfamiliarwith the workings of the ßexible exchange rate system.1 A potential econometric problem in Isard’s analysis is that he runs the regressionR t = a 0 + a 1 S t + a 2 D t + e t + ρe t−1 where R t is the ratio of import to export prices,S t is the DM price of the dollar, and D t is a dummy variable that splits up thesample. The problem is that the regression is run by Cochrane—Orcutt to controlfor serial correlation in the error term, e t , which is inconsistent if the regressors arenot strictly (econometrically) exogenous.