# Then the real exchange rate cannot change theory of

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Then the real exchange rate cannot change Theory of purchasing-power parity Nominal exchange rate between the currencies of two countries Must reflect the price levels in those countries 12

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Purchasing-Power Parity Implications of purchasing-power parity The Most Important and Obvious implication Real Exchange Rate is unity. So RER = 1 Because we must have P = P’/e or alternatively P x e = P’ And RER was defined as (P x e)/P’ 13
With PPP we must have: e = P’/P If there is a sharp rise in P, there will be a sharp drop in e. Turns out this is easy to test during the periods of hyperinflation German Experience: Take e and P as the domestic price level and exchange rate (for dollars) of Germany Testing Purchasing Power Parity 14

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Natural experiment – hyperinflation High inflation Arises when a government – prints money to pay for large amounts of government spending German hyperinflation, early 1920s Money supply, price level, nominal exchange rate Move closely together Money supply - starts growing quickly Price level – starts growing Depreciation The nominal exchange rate during a hyperinflation 15
German hyperinflation, early 1920s Money supply - stabilizes Price level – stabilizes Exchange rate - stabilizes During every hyperinflation Fundamental link among Money supply, prices, and nominal exchange rate Quantity theory of money Explains how the money supply affects price level Purchasing power parity Explains how price level affects nominal exchange rate The nominal exchange rate during a hyperinflation 16

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Money, prices, and the nominal exchange rate during the German hyperinflation 3 17 This figure shows the money supply, the price level, and the exchange rate (measured as U.S.
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