Tax Rate Reductions and
Foreign Exchange Rates
VICTOR A. CANTO
A subtle but important distinction is being neglected in current discussions of the foreign exchange value of the U.S. dollar. It is true that monetary disturbances, such as a deliberate devaluation of a country's currency, will lead to roughly offsetting inflation. It also is true that under a regime of floating exchange rates, differential inflation rates resulting from monetary disturbances will lead to a roughly offsetting change in exchange rates. These relationships reflect what is commonly referred to as purchasing power parity.
The long-run relevance of purchasing power parity is exceptionally strong. A close correspondence exists between the movement of foreign price levels (converted to dollars) and the movements of prices in the United States. However, saying that monetary disturbances result in differential inflation rates and offsetting exchange rate changes does not preclude other factors from also affecting exchange rates. Under a domestic price rule with floating exchange rates, real disturbances, such as fiscal policy changes or shifts in the terms of trade, can cause dramatic changes in exchange rates without the slightest pressure for offsetting inflation. Under fixed exchange rates, real disturbances can also result in differential inflation rates that do not exert any pressure on the foreign exchange markets. In such cases, purchasing power parity will not hold.
The concept of purchasing power parity maintains that the equilibrium exchange rate between the currencies of two countries equals the ratio of their price levels. This, in turn, implies that differences between the inflation rates of two countries will correspond to proportionate changes in the exchange rate. From