The reversal of the relation between the U.S. interest and the external value of the dollar which has taken place since mid 1979, indicates that currently the prime cause for fluctuations in U.S. interest rates is not variations in inflationary expectations but rather variations in the real rate of interest which are occasioned by large U.S. budget deficit.#
To some extent the overall poor performance of the purchasing power parities doctrine is specific to the 1970s. During the floating rates period of the 1920s, the doctrine seems to have been much more reliable.#
Those who advocate the use of traded good prices [in bringing about purchasing power parity] emphasize the role of commodity arbitrage as the mechanism which governs the relationship between prices and the exchange rate, while those who advocate the broader price index emphasize the role of equilibrium in asset markets as a major factor governing the relationship between prices and the exchange rate.
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This pattern of ‘causality’ [that exchange rates granger-cause prices, rather than vice versa] is consistent with the hypothesis that speeds of adjustment in asset markets exceed those in the commodity markets. Thus, to the extent that exchange rates and commodity prices are influenced by common factors, the differential speed of adjustment may yield the observed pattern of ‘causality’.#
The relationship embodied in the traditional formulations of [purchasing power parity] should not be viewed as a theory of the determination of exchange rates. Rather, it describes an equilibrium relationship between two endogenous variables. As such, the PPP relationship should be viewed as a short-cut rather than a substitute for a complete model of the determination of prices and exchange rates. #