The Dollar Strikes Back

October 27, 2008

Is the rise due to the current credit crisis, or based on economic fundamentals?

 

A surprising bright point in the current financial turmoil is the rise of the dollar. Since the beginning of the year, the dollar has strengthened by 16% compared to the euro and by 26% compared to the British pound. The only exception, among the main currencies, is the Japanese yen, which rose by 19% compared to the dollar.

So where does the strength of the dollar come from? Many explanations appeared in the financial media that attributed (paradoxically) the strength of the dollar to the current crisis. I want to propose a different explanation that is based on economic fundamentals.

Ask an economist about the "correct" exchange rate and the most likely answer will be purchasing power parity (PPP).

 

"Under the skin of any international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate," wrote Paul Krugman—the Nobel-prize winner—and Rudiger Dornbusch, more than thirty years ago. (Dornbusch, Rudiger & Krugman, Paul, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy)

 

The PPP model is based on the Law of One Price, which states that identical products that are traded without limitation and with no taxes, will be sold at the same price anywhere in the world. Examples of the Law of One Price are commodities, precious metals, natural gas and oil that are traded in various international exchanges at almost identical prices. The Law of One Price works because if the situation were different, there was an opportunity for arbitrage: If a barrel of crude oil were traded in different prices in different places in the world, it was possible to buy it where it is cheap and to sell it with a profit where it is more expensive. As a result, there would be excess demand for oil in the place where the price is lower, which would cause a higher price, and excess supply of oil where the price is higher, which would cause a lower price. The opportunity for arbitrage would stop only after the prices in the two places equate.

The PPP model extends the Law of One Price and states that the equilibrium exchange rate between two currencies is the rate in which an identical basket of goods and services will cost the same in the two countries. In any other situation, the opportunity for arbitrage will push the exchange rate back to its equilibrium value.

Can the PPP model predict the market exchange rate?

An article published a few years ago summarizes the current knowledge about the PPP model:

 

"Neither absolute nor relative PPP appear to hold closely in the short run, although both appear to hold reasonably well as a long-run average and when there are large movements in relative prices. ... In other words, as far as exchange rates are concerned, the fundamental things-relative price levels-apply increasingly as time goes by. These conclusions are in fact broadly in line with the current consensus view on PPP." (Alan M. Taylor and Mark P. Taylor, 2004, "The Purchasing Power Parity Debate," Journal of Economic Perspectives.)

 

The researchers add two qualifications to their conclusion:

 

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