674PART ELEVENTHE MACROECONOMICS OF OPEN ECONOMIESLIMITATIONS OF PURCHASING-POWER PARITYPurchasing-power parity provides a simple model of how exchange rates are de-termined. For understanding many economic phenomena, the theory works well.In particular, it can explain many long-term trends, such as the depreciation of theU.S. dollar against the German mark and the appreciation of the U.S. dollaragainst the Italian lira. It can also explain the major changes in exchange rates thatoccur during hyperinflations.Yet the theory of purchasing-power parity is not completely accurate. That is,exchange rates do not always move to ensure that a dollar has the same real valuein all countries all the time. There are two reasons why the theory of purchasing-power parity does not always hold in practice.The first reason is that many goods are not easily traded. Imagine, for instance,that haircuts are more expensive in Paris than in New York. International travelers
This is the end of the preview.
access the rest of the document.