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Supply and demand determine a freely floating exchange rate. The purchasing
power parity doctrine concerns the approximate level at which supply and
demand will balance. The doctrine notes that people value currencies for what
they will buy. If one Inland dollar buys as much goods and services as three
Outland pesos, a free exchange rate would hover in the range of three pesos
per dollar, 33 cents per peso. An actual rate that unmistakably undervalued the
peso, say 20 cents, would make Outland goods seem great bargains to Inlanders
and make Inland goods seem overpriced to Outlanders. Inland eagerness to buy
Outland goods and Outland reluctance to buy Inland goods would flood the
foreign exchange market with dollars seeking to buy scarce pesos. The
imbalance would eventually bid the rate back toward its purchasing power
parity. Corrective pressures would operate through changes in both the
quantities and the mix of goods traded.
Comparing two countries price levels to calculate a purchasing power parity
presupposes some one assortment of goods and services that can be priced in
Money in an open economy 261
both countries and that accurately represents the types and relative quantities
of various goods and services produced and consumed in each. In fact, no one
assortment can typify the patterns of production and consumption in both of
two countries, so a direct comparison of purchasing powers is impractical or
dubious. If a calculation is nevertheless required, it is typically a makeshift.
The current parity exchange rate is estimated from changes in the purchasing
powers of the two currencies since some past base period when the actual rate
was supposedly in equilibrium. If the Inland price level has tripled over a certain
period of time while the Outland level has been multiplied by six if Outlanders
have suffered twice as much price inflation as Inlanders then the dollar should
be worth about twice as many pesos as before.
The convenience of using each countrys own price index, constructed in its
own way and representative of the local economy, is also a source of weakness.
The purchasing power parity doctrine is mainly concerned with the forces at
work determining an exchange rate at a given point in time, yet the calcula-
tions deal with price level changes over a span of time, during which many
sorts of changes may have robbed a price index of accuracy and even of clear
meaning. For many reasons, moreover, the base period actual exchange rate
used in the calculation may not have been an equilibrium rate. Tariffs and other
trade barriers may have become more or less severe since the base period.
All these difficulties concern makeshift calculations and do not impugn the
logic of the purchasing power parity doctrine itself. Fundamentally the doctrine
is a theory of monetary influences on exchange rates monetary influences
reflected in price levels. It is closely associated with the quantity theory of price
level determination. Meinich (1968) generalizes Patinkins quantity theory
(1956, 1965) to an open economy. Making simplifying assumptions similar to
Patinkins and working on a similar level of abstraction, Meinich shows, for
example, that doubling the supply of domestic money, given unchanged money
supplies abroad, would result in a doubled price level and a doubled home-
currency price of foreign exchange. Similarly, Patinkin (1989, pp. xxxixxlii)
generalizes his 1965 model of the neutrality of money to the small open
economy. He also shows how a doubling of the money supply results in a
doubling of the price level and price of foreign exchange with an unchanged rate
of interest.
Correctly understood, neither the quantity theory nor the purchasing power
parity doctrine denies that all sorts of influences besides money affect price
levels and exchange rates. Real factors affecting terms of trade and capital
movements, and even speculative capital movements, can of course affect
exchange rates. When these factors are strong, they can swamp and obscure
the influence of relatively small monetary changes reflected in price levels.
A major theme of this book is that one must go beyond the simple mechanics
of the quantity theory (or in this case purchasing power parity) in order to
262 Monetary theory
Since 197173 floating rates have moved erratically. Over periods of hours,
months and perhaps even years, capital transactions have far overshadowed
trade in goods and services in determining exchange rates. As someone who
has always strongly favored floating exchange rates, Milton Friedman (1985)
admits that he did not anticipate the volatility in the foreign exchange markets
that weve had.9 Bilateral rates have fluctuated 10 and 20 percent over periods
of months and sometimes several percent from day to day or even within days.
Contrary to hopes pinned earlier on the development of market institutions and
the accumulation of experience, rate fluctuations appear not to have been getting
milder over time. How serious its consequences are is not clear. Volatility seems
not to have impaired the volume of international trade, or not enough for the
effect to be detectable beyond dispute (Aschheim, Bailey and Tavlas, 1987,
especially pp. 43341). Capital movements have flourished, perhaps exces-
sively in some sense.
Exchange rates in part have the character of asset prices, jumping around like
stock prices (if not that widely) as asset-holders seek to rearrange their
portfolios. Movements (overshooting) of exchange rates ahead of or in exag-
geration of or otherwise out of correspondence with the relative purchasing
Money in an open economy 263
It is not meaningful to question the validity of the three approaches. The terms can
be defined so that they are correct and assert identical propositions, even if capital
movements are included...The identity of the three approaches, when they are properly
interpreted, does not mean that each approach is not in itself useful. [Each approach]
provides additional checks on the logic of balance-of-payments policies.
On the other hand, the strong version of the MABP, associated with Harry
G. Johnson and his followers, is a theory that happens not to be generally valid.
It identifies a countrys balance-of-payments surplus with an excess demand for
money and a balance-of-payments deficit with an excess supply of money. It
denies the possibility that imposed surpluses and deficits can create monetary
disequilibrium. Rather, it views the balance of payments solely as an equili-
brating mechanism that helps remove an excess demand for or supply of
money. For example, this theory views the surplus that follows a devaluation
from equilibrium as a process that eliminates an excess demand for money.
Johnson (1972, p. 91; 1976, pp. 2734) states:
The effect of devaluation is transitory, working through the restoration of the publics
actual to its desired real balances via the impact of an excess demand for money in
producing a surplus...The balance-of-payments surplus will continue only until its
cumulative effect in increasing domestic money holdings satisfies the domestic
demand for money.