I n t h I s c h a p t e r y o u w I l L

According to the theory of purchasing-power parity, the
nominal exchange rate between the currencies of two countries must reflect the different
price levels in those countries.
A key implication of this theory is that nominal exchange rates change when
price levels change. As we saw in the preceding chapter, the price level in any
country adjusts to bring the quantity of money supplied and the quantity of
money demanded into balance. Because the nominal exchange rate depends on
the price levels, it also depends on the money supply and money demand in each
country. When a central bank in any country increases the money supply and
causes the price level to rise, it also causes that country’s currency to depreciate
relative to other currencies in the world. In other words, 
when the central bank prints
large quantities of money, that money loses value both in terms of the goods and services it
can buy and in terms of the amount of other currencies it can buy.
We can now answer the question that began this section: Why has the U.S. dol-
lar lost value compared to the German mark and gained value compared to the
Italian lira? The answer is that Germany has pursued a less inflationary monetary
policy than the United States, and Italy has pursued a more inflationary monetary
policy. From 1970 to 1998, inflation in the United States was 5.3 percent per year.
By contrast, inflation was 3.5 percent in Germany, and 9.6 percent in Italy. As U.S.
prices rose relative to German prices, the value of the dollar fell relative to the
mark. Similarly, as U.S. prices fell relative to Italian prices, the value of the dollar
rose relative to the lira.

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6 7 4
PA R T E L E V E N
T H E M A C R O E C O N O M I C S O F O P E N E C O N O M I E S
L I M I TAT I O N S O F P U R C H A S I N G - P O W E R PA R I T Y
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
might avoid getting their haircuts in Paris, and some haircutters might move from
New York to Paris. Yet such arbitrage would probably be too limited to eliminate
the differences in prices. Thus, the deviation from purchasing-power parity might
persist, and a dollar (or franc) would continue to buy less of a haircut in Paris than
in New York.
The second reason that purchasing-power parity does not always hold is that
even tradable goods are not always perfect substitutes when they are produced in
different countries. For example, some consumers prefer German beer, and others
prefer American beer. Moreover, consumer tastes for beer change over time. If Ger-
man beer suddenly becomes more popular, the increase in demand will drive up
10,000,000,000
1,000,000,000,000,000
100,000
1
.00001
.0000000001
1921
1922
1923
1924
Exchange rate
Money supply
Price level
1925
Indexes
(Jan. 1921 
100)
F i g u r e 2 9 - 3
M
ONEY
, P
RICES
, 
AND THE
N
OMINAL
E
XCHANGE
R
ATE
DURING THE
G
ERMAN
H
YPERINFLATION
.
This figure
shows the money supply, the
price level, and the exchange rate
(measured as U.S. cents per
mark) for the German
hyperinflation from January 1921
to December 1924. Notice how
similarly these three variables
move. When the quantity of
money started growing quickly,
the price level followed, and the
mark depreciated relative to the
dollar. When the German central
bank stabilized the money
supply, the price level and
exchange rate stabilized as well.
S
OURCE
: Adapted from Thomas J. Sargent,
“The End of Four Big Inflations,” in Robert
Hall, ed., 
Inflation
(Chicago: University of
Chicago Press, 1983), pp. 41–93.

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C H A P T E R 2 9
O P E N - E C O N O M Y M A C R O E C O N O M I C S : B A S I C C O N C E P T S
6 7 5
C A S E S T U D Y
THE HAMBURGER STANDARD
When economists apply the theory of purchasing-power parity to explain ex-
change rates, they need data on the prices of a basket of goods available in dif-
ferent countries. One analysis of this sort is conducted by 
The Economist,
an
international newsmagazine. The magazine occasionally collects data on a bas-
ket of goods consisting of “two all beef patties, special sauce, lettuce, cheese,
pickles, onions, on a sesame seed bun.” It’s called the “Big Mac” and is sold by
McDonald’s around the world.
Once we have the prices of Big Macs in two countries denominated in the
local currencies, we can compute the exchange rate predicted by the theory of
purchasing-power parity. The predicted exchange rate is the one that makes the
cost of the Big Mac the same in the two countries. For instance, if the price of a
Big Mac is $2 in the United States and 200 yen in Japan, purchasing-power par-
ity would predict an exchange rate of 100 yen per dollar.
How well does purchasing-power parity work when applied using Big Mac
prices? Here are some examples from an 
Economist 
article published on April 3,
1999, when the price of a Big Mac was $2.43 in the United States: