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Principles of Economics- Mankiw (5th) 652

Principles of Economics- Mankiw (5th) 652 - 674 PA R T E L...

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674 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES LIMITATIONS OF PURCHASING-POWER PARITY Purchasing-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 the U.S. dollar against the German mark and the appreciation of the U.S. dollar against the Italian lira. It can also explain the major changes in exchange rates that occur 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 value in 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
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