KEY POINTS

1. Purchasing power parity (PPP) implies that the exchange rate should equal the relative price level in the two countries, and the real exchange rate should equal 1.
2. Evidence for PPP is weak in the short run but more favorable in the long run. In the short run, deviations are common and changes in the real exchange rate do occur. The failure of PPP in the short run is primarily the result of market frictions, imperfections that limit arbitrage, and price stickiness.
3. A simple monetary model (the quantity theory) explains price levels in terms of money supply levels and real income levels. Because PPP can explain exchange rates in terms of price levels, the two together can be used to develop a monetary approach to the exchange rate.
4. If we can forecast money supply and income, we can use the monetary approach to forecast the level of the exchange rate at any time in the future. However, the monetary approach is valid only under the assumption that prices are flexible. This assumption is more likely to hold in the long run, so the monetary approach is not useful in the short run forecast. Evidence for PPP and the monetary approach is more favorable in the long run.
5. PPP theory, combined with uncovered interest parity, leads to the strong implications of the Fisher effect (interest differentials between countries should equal inflation differentials). The Fisher effect says that changes in local inflation rates pass through one for one into changes in local nominal interest rates. The result implies real interest parity (expected real interest rates should be equalized across countries). Because these results rest on PPP, they should be viewed only as long-run results, and the evidence is somewhat favorable.
6. We can augment the simple monetary model (quantity theory) to allow for the demand for real money balances to decrease as the nominal interest rate rises. This leads to the general monetary model. Its predictions are similar to those of the simple model, except that a one-time rise in money growth rates leads to a one-time rise in inflation, which leads to a one-time drop in real money demand, which in turn causes a one-time jump in the price level and the exchange rate.
7. The monetary approach to exchange rate determination in the long run has implications for economic policy. Policy makers and the public generally prefer a low-inflation environment. Various policies based on exchange rates, money growth, or interest rates have been proposed as nominal anchors. Recent decades have seen a worldwide decline in inflation thanks to the explicit recognition of the need for nominal anchors.