Purchasing Power Parity and the Dollar

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10.27.09

In terms of purchasing power parity, the dollar seems a tad undervalued these days, but that does not mean it will soon appreciate. Exchange rates can deviate from their purchasing-power-parity levels for long periods. What's more, the necessary adjustment can come through prices, not exchange rates.

People value money for what it buys, and, given the opportunity, they will use the national currency that offers them the greatest purchasing power. If, for example, goods are cheaper in Mexico than in the United States, Americans will trade U.S. dollars for Mexican pesos and buy Mexican goods. Such cross-border arbitrage should affect both exchange rates and prices so as to promote parity among the purchasing powers of the world's currencies. This idea--purchasing power parity--is fundamental to many economic models of exchange-rate behavior and to some descriptions of the dollar's equilibrium value. Observers who complain that the dollar is overvalued or undervalued often do so with reference to the dollar's purchasing-power-parity value.

One way to get a quick fix on the dollar's purchasing-power-parity value is to look at a real exchange rate. Real exchange rates mathematically combine nominal exchange rates--the kind you can find in a newspaper--and price indexes--like consumer price indexes. A rising dollar real exchange rate indicates that American goods, when expressed in a common currency, are becoming more expensive than foreign goods, or that the United States is losing its competitive edge.

Using a real exchange rate to judge whether the dollar is overvalued or undervalued, however, requires some reference point at which purchasing power parity holds. Such a point should also be consistent with a global balance-of-payments configuration that is sustainable. …