Empirical Evidence on PPP and the Law of One Price
How well does the PPP theory explain actual data on exchange rates and national price
levels? A brief answer is that all versions of the PPP theory do badly in explaining the
facts. In particular, changes in national price levels often tell us relatively little about
exchange rate movements.
Do not conclude from this evidence, however, that the effort you’ve put into learning about
PPP has been wasted. As we’ll see later in this chapter, PPP is a key building block of
exchange rate models that are more realistic than the monetary approach. Indeed, the empirical
failures of PPP give us important clues about how more realistic models should be set up.
To test absolute PPP, economic researchers compare the international prices of a broad
reference basket of commodities, making careful adjustments for intercountry quality
differences among supposedly identical goods. These comparisons typically conclude that
absolute PPP is way off the mark: The prices of identical commodity baskets, when converted
to a single currency, differ substantially across countries. Even the law of one price has not
fared well in some recent studies of price data broken down by commodity type.
Manufactured goods that seem to be very similar to each other have sold at widely different
prices in various markets since the early 1970s. Because the argument leading to absolute PPP
builds on the law of one price, it is not surprising that PPP does not stand up well to the data.6
Relative PPP is sometimes a reasonable approximation to the data, but it, too, usually performs
poorly. Figure 16-2 illustrates relative PPP’s weakness by plotting both the yen/dollar
exchange rate, , and the ratio of the Japanese and U.S. price levels, , through 2009.
Price levels are measured by indexes reported by the Japanese and U.S. governments.7
Relative PPP predicts that and will move in proportion, but clearly they do
not. In the early 1980s there was a steep appreciation of the dollar against the yen even
though, with Japan’s price level consistently falling relative to that in the United States,
relative PPP suggests that the dollar should have depreciated instead. The same inflation
trends continued after the mid-1980s, but the yen then appreciated by far more than the
amount that PPP would have predicted. Only over fairly long periods is relative PPP
approximately satisfied. In view of the lengthy departures from PPP in between, however,
that theory appears to be of limited use even as a long-run explanation.
Studies of other currencies largely confirm the results in Figure 16-2. Relative PPP has
not held up well.8 As you will learn later in this book, between the end of World War II
E¥/$ PJ/PUS
E¥/$ PJ/PUS
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 395
in 1945 and the early 1970s, exchange rates were fixed within narrow, internationally
agreed-upon margins through the intervention of central banks in the foreign exchange
market. During that period of fixed exchange rates, PPP did not do too badly. However,
during the first half of the 1920s, when many exchange rates were market-determined as
in the 1970s and after, important deviations from relative PPP occurred, just as in recent
decades
How well does the PPP theory explain actual data on exchange rates and national price
levels? A brief answer is that all versions of the PPP theory do badly in explaining the
facts. In particular, changes in national price levels often tell us relatively little about
exchange rate movements.
Do not conclude from this evidence, however, that the effort you’ve put into learning about
PPP has been wasted. As we’ll see later in this chapter, PPP is a key building block of
exchange rate models that are more realistic than the monetary approach. Indeed, the empirical
failures of PPP give us important clues about how more realistic models should be set up.
To test absolute PPP, economic researchers compare the international prices of a broad
reference basket of commodities, making careful adjustments for intercountry quality
differences among supposedly identical goods. These comparisons typically conclude that
absolute PPP is way off the mark: The prices of identical commodity baskets, when converted
to a single currency, differ substantially across countries. Even the law of one price has not
fared well in some recent studies of price data broken down by commodity type.
Manufactured goods that seem to be very similar to each other have sold at widely different
prices in various markets since the early 1970s. Because the argument leading to absolute PPP
builds on the law of one price, it is not surprising that PPP does not stand up well to the data.6
Relative PPP is sometimes a reasonable approximation to the data, but it, too, usually performs
poorly. Figure 16-2 illustrates relative PPP’s weakness by plotting both the yen/dollar
exchange rate, , and the ratio of the Japanese and U.S. price levels, , through 2009.
Price levels are measured by indexes reported by the Japanese and U.S. governments.7
Relative PPP predicts that and will move in proportion, but clearly they do
not. In the early 1980s there was a steep appreciation of the dollar against the yen even
though, with Japan’s price level consistently falling relative to that in the United States,
relative PPP suggests that the dollar should have depreciated instead. The same inflation
trends continued after the mid-1980s, but the yen then appreciated by far more than the
amount that PPP would have predicted. Only over fairly long periods is relative PPP
approximately satisfied. In view of the lengthy departures from PPP in between, however,
that theory appears to be of limited use even as a long-run explanation.
Studies of other currencies largely confirm the results in Figure 16-2. Relative PPP has
not held up well.8 As you will learn later in this book, between the end of World War II
E¥/$ PJ/PUS
E¥/$ PJ/PUS
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 395
in 1945 and the early 1970s, exchange rates were fixed within narrow, internationally
agreed-upon margins through the intervention of central banks in the foreign exchange
market. During that period of fixed exchange rates, PPP did not do too badly. However,
during the first half of the 1920s, when many exchange rates were market-determined as
in the 1970s and after, important deviations from relative PPP occurred, just as in recent
decades
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