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80 CHAPTER 3. THE MONETARY MODEL3.1 Purchasing-Power ParityA key building block of the monetary model is purchasing-power parity(PPP), which can be motivated according to the Casellian approach orby the commodity-arbitrage view.Cassel’s ApproachThe intellectual origins of PPP began in the early 1800s with the writingsof Wheatly and Ricardo. These ideas were subsequently revivedby Cassel [22]. The Casselian approach begins with the observationthat the exchange rate S is the relative price of two currencies. Sincethe purchasing power of the home currency is 1/P and the purchasingpower of the foreign currency is 1/P ∗ , in equilibrium, the relative valueof the two currencies should reßect their relative purchasing powers,S = P/P ∗ .What is the appropriate deÞnition of the price level? The Casselianview suggests using the general price level. Whether the general pricelevel samples prices of non-traded goods or not is irrelevant. As aresult, the consumer price index (CPI) is typically used in empiricalimplementations of this theory. The following passage from Cassel isused by Frenkel [60] to motivate the use of the CPI in PPP research.“Some people believe that Purchasing Power Paritiesshould be calculated exclusively on price indices for suchcommodities as for the subject of trade between the twocountries. This is a misinterpretation of the theory . . . Thewhole theory of purchasing power parity essentially refersto the internal value of the currencies concerned, and variationsin this value can be measured only by general indexÞgures representing as far as possible the whole mass ofcommodities marketed in the country.”The theory implies that the log real exchange rate q ≡ s + p ∗ − pis constant over time. However, even casual observation rejects thisprediction. Figure 3.1 displays foreign currency values of the US dollarand PPPs relative to four industrialized countries formed from CPIs
3.1. PURCHASING-POWER PARITY 81US-UK1.210.80.60.40.2073 75 77 79 81 83 85 87 89 91 93 95 97-0.2US-Germany0.80.70.60.50.40.30.20.10-0.1-0.273 75 77 79 81 83 85 87 89 91 93 95 97US-Japan1.41.210.80.60.40.20-0.2-0.473 75 77 79 81 83 85 87 89 91 93 95 97US-Switzerland1.210.80.60.40.20-0.273 75 77 79 81 83 85 87 89 91 93 95 97Figure 3.1: Log nominal exchange rates (boxes) and CPI-based PPPs(solid).expressed in logarithms over the ßoating period. Figure 3.2 shows theanalogous series for the US and UK over a long historical period extendingfrom 1871 to 1997. While there are protracted periods in whichthe nominal exchange rate deviates from the PPP, the two series tendto revert towards each other over time.As a result, international <strong>macroe</strong>conomists view Casselian PPP asa theory of the long-run determination of the exchange rate in whichthe PPP (p − p ∗ ) is a long-run attractor for the nominal exchange rate.
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To Shirley, Laurie, and Leslii
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CONTENTSvii11 Balance of Payments C
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2 CHAPTER 1. SOME INSTITUTIONAL BAC
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130 CHAPTER 4. THE LUCAS MODELdisco
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132 CHAPTER 4. THE LUCAS MODEL1.02A
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134 CHAPTER 4. THE LUCAS MODELAppen
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136 CHAPTER 4. THE LUCAS MODELProbl
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138 CHAPTER 5. INTERNATIONAL REAL B
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162CHAPTER 6. FOREIGN EXCHANGE MARK
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208 CHAPTER 7. THE REAL EXCHANGE RA
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230 CHAPTER 8. THE MUNDELL-FLEMING
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264CHAPTER 9. THE NEW INTERNATIONAL
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308 CHAPTER 10. TARGET-ZONE MODELSa
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310 CHAPTER 10. TARGET-ZONE MODELSt
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312 CHAPTER 10. TARGET-ZONE MODELSC
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314 CHAPTER 10. TARGET-ZONE MODELSl
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316 CHAPTER 10. TARGET-ZONE MODELST
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318 CHAPTER 10. TARGET-ZONE MODELSa
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320 CHAPTER 10. TARGET-ZONE MODELSM
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322 CHAPTER 10. TARGET-ZONE MODELSt
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324 CHAPTER 10. TARGET-ZONE MODELS
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326 CHAPTER 10. TARGET-ZONE MODELS
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328 CHAPTER 11. BALANCE OF PAYMENTS
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358 AUTHOR INDEXFama, E.F., 161, 16
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Subject IndexAAbsorption, 16, 230AI
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362 SUBJECT INDEXEfficient capital
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364 SUBJECT INDEXMethod of undeterm
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366 SUBJECT INDEXRisk neutrality, 9
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368 SUBJECT INDEXImpulse response a
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