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Essay on Purchasing Power Parity Analysis
Abstract
The purpose of this paper is to make the analysis of the purchase power parity and discuss the impact of the International Fisher Effect
EURO and US Dollar
Indexed exchange rate and trade data
Four factors are identified as fundamental determinants of the real euro to dollar exchange rate:
- The international real interest rate differential
- Relative prices in the traded and non-traded goods sectors
- The real oil price
- The relative fiscal position
The nominal bilateral dollar to euro exchange is the exchange rate that attracts the most attention. Notwithstanding the comparative importance of euro to US dollar bilateral trade links, trade with the UK is, to some extent, more important for the Euro zone than is trade with the US. The dollar and the euro have a strong predisposition to run together in the very short run, but sometimes there can be significant discrepancies. The very strong appreciation of the dollar against the euro in 2003 is one example of these discrepancies.
In the long run, the correlation between the bilateral dollar to euro exchange rate, and different measures of the effective exchange rate of Euroland, has been rather high, especially if one looks at the effective real exchange rate. As inflation is at very similar levels in the US and the Euro area, there is no need to adjust the dollar to euro rate for inflation differentials, but because the Euro zone also trades intensively with countries that have relatively high inflation rates (e.g. some countries in Central and Eastern Europe, Turkey, etc.), it is more important to downplay nominal exchange rate measures by looking at relative price and cost developments. (Alquist, and Chinn, 2002)
The basic theories underlying the dollar to euro exchange rate:
Law of One Price: In competitive markets free of transportation cost barriers to trade....
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