The purchasing power parity and exchange-rate economics half a century on

Abstract

The value of a country's currency is often considered as the most important price in the economy. Exchange-rate changes can significantly affect the profitability of exporters, the prices paid by consumers, as well as complicating the comparison of the economies of different countries. In this article, we illustrate the workings of the purchasing power parity (PPP) and demonstrate its practical use with cross-country data covering the 50 years since the collapse of the Bretton Woods monetary system. We find that despite the prolonged gyrations of currency values and the multitude of trade barriers, the forces of arbitrage and resource re-allocation are sufficient to overcome many of these distortions in the longer term. We also provide a broad survey of other prominent themes, both extant and emerging, in international economics that highlight the importance of the relationship between exchange rates and prices.