International macroe.. - Free

82 CHAPTER 3. THE MONETARY MODEL6040200-20-40-60-80Nominal Exchange Rate (solid)PPPs from CPIs (boxes)-100-1201871 1882 1893 1904 1915 1926 1937 1948 1959 1970 1981 1992Figure 3.2: US—UK log nominal exchange rates and CPI-based PPPsmultiplied by 100. 1871-1997.The Commodity-Arbitrage ApproachThe commodity-arbitrage view of PPP, articulated by Samuelson [124],simply holds that the law-of-one price holds for all internationally tradedgoods. Thus if the law-of-one price holds for the goods individually, itwill hold for the appropriate price index as well. Here, the appropriateprice index should cover only those goods that are traded internationally.It can be argued that the producer price index (PPI) is a betterchoice for studying PPP since it is more heavily weighted towardstraded goods than the CPI which includes items such as housing serviceswhich do not trade internationally. We will consider empiricalanalyses on PPP in chapter 7.PPP is clearly violated in the short run. Casual observation ofFigures 3.1 and 3.2 suggest however that PPP may hold in the longrun. There exists econometric evidence to support long-run PPP, butwe will defer discussion of these issues until chapter 7.In spite of the obvious short-run violations, PPP is one of the buildingblocks in the monetary model and as we will see in the Lucas model