The Long-Term Behaviour of Exchange Rates, Part I: Introduction

In 1972, just prior to the collapse of the Bretton-Woods system of fixed exchange rates, the US dollar cost about .4 British pounds. By 1985, the dollar had appreciated to .9 pounds, but by 2001 it had fallen back to about .7 pounds. Such substantial changes in currency values over the longer term are commonplace in a world of floating exchange rates. The thesis aims to enhance understanding of such long-term movements in exchange rates by focusing on one of the central pillars of international economics, purchasing power parity (PPP) theory. This provides the fundamental link between exchange rates and prices, and is the theoretical foundation underlying many exchange-rate models. We present an extensive review of PPP theory and highlight the role of real factors such as international productivity differences in determining exchange rates over the longer term. We also demonstrate that PPP is one of the most rapidly expanding areas of research in economics, and present an analytical overview of the PPP literature. The Big Mac Index, invented by The Economist magazine in 1986, has played a major role in popularising PPP and bringing its practical implications to the attention of financial markets in particular. This thesis tests for PPP using the Big Mac data. We use enhanced econometric procedures that deal with problems of bias and estimation uncertainty associated with a small sample. The test results not only favour PPP, but also suggest a shorter half-life of deviations from parity than that previously reported in much of the literature. As PPP holds, there exists a long-run equilibrium value to which the actual exchange rate reverts, which we identify with the “equilibrium exchange rate” (EER). We introduce a new methodology based on Monte Carlo techniques to estimate the whole distribution of the EER and the adjustment path of the actual rate into the future. This new approach seems to have a number of attractive features including its modest data requirements (exchange rates and Big Mac prices), the minimal economic structure placed on the problem and its simplicity. Interestingly, our estimates of EERs are quite close to those of other studies using more complex methodologies.