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We saw that a rise in a country’s real interest rate, with no change in other countries’ real interest rates, causes a net capital inflow. We discussed how this would affect the balance of payments and consequently influence other economic variables of interest. One impact of the net capital inflow that we did not discuss was its effect on the real interest rate itself.

Suppose, for example, that the real interest rate in a small country such as Canada rises, creating a net capital inflow into Canada. This puts downward pressure on the Canadian real interest rate. This result occurs for two reasons. First, foreigners will want to invest in Canadian bonds to obtain the higher return, so the demand for Canadian bonds increases, bidding up Canadian bond prices and thereby lowering the Canadian real interest rate. Second, Canadian firms selling bonds will find it cheaper to raise capital in other countries, so they will remove their bonds from the Canadian market and take them to foreign bond markets. The fall in the supply of bonds on the Canadian market also causes the price of Canadian bonds to rise, thus lowering the Canadian real interest rate.

The bottom line here is that a rise in the Canadian real interest rate sets in motion forces that push this interest rate back toward the ‘’world” real rate of interest. In general, however, these forces will not succeed in pushing the Canadian interest rate all the way to the “world” real rate because the relationship between the “world” real rate and a specific country’s real rate is only approximate.

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Like the formula for inflation from chapter 9, the PPP relationship is best described as a rule of thumb for predicting long-run behavior. In the short run, exchange rate changes are very volatile, affected by political events, business cycles, speculator activity, monetary policies, and rumors affecting financial markets, among many other things. Consequently, PPP is unlikely in the short run to be a good guide to exchange rate behavior.

Even in the long run, PPP can be a poor guide because it ignores a variety of factors that permanently influence our ability to compete on international markets:

1. Natural resource discoveries such as Alaska or North Sea oil.

2. Invention of new products such as VCRs.

3. Changes in barriers to trade such as tariff reductions associated with free trade agreements.

4. Changes in consumers’ tastes for imported versus domestic goods.

5. Permanent changes in countries’ relative real interest rates.

6. Differing rates of productivity growth across countries.

7. Overall inflation rates not accurately reflecting price changes in traded goods and services.

All the factors listed above can permanently affect the exchange rate in the long run in the absence of inflation, thus invalidating the PPP result and marking a difference between the real and nominal exchange rates. This difference is illustrated in figure 17.2. A large swing in the real U.S. exchange rate occurred during the 1980s as the result of a high relative U.S. real shrinks, eventually by enough to cause forces for change to arise. Thus, by looking at inflation differences, more confidence can be placed in the PPP prediction, at least insofar as the long-run picture is concerned.

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In the example in which U.S. inflation is 8 percent and foreign inflation 5 percent, we saw that under a flexible exchange rate system the U.S. dollar would depreciate by 3 percent per year. This 3 percent annual depreciation just offsets the annual relative increase in U.S. prices of 3 percent, so there should be no incentive for anyone to change demand for imports or exports. Although there has been a change in the nominal exchange rate, there has been no change in the real exchange rate.

The nominal exchange rate is the one we read about in the newspaper. It tells us the rate at which our currency exchanges for foreign currencies. The real exchange rate, sometimes called the terms of trade, tells us the rate at which our goods and services exchange for foreign goods and services; it is therefore the exchange rate that influences imports and exports.

The domestic to foreign price ratio in this formula is calculated as the cost of a typical basket of traded goods and services in the United States in U.S. dollars divided by the cost of that same basket in the foreign country in its currency.

From this formula, if U.S. prices increase by 8 percent per year and foreign prices increase by 5 percent per year, then each year the ratio of their price levels increases by about 3 percent, canceled out by the 3 percent fall in the nominal exchange rate. The real exchange rate is unchanged, as it should be in this example. A crucial assumption in the PPP rule of thumb is that the real exchange rate is constant, something we know is not true. Figure 17.2 shows how the real exchange rate can change dramatically in response to factors such as real interest rate differentials.

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In 1944, when an Allied victory was certain, the Allies held a conference at Bretton Woods, New Hampshire, to discuss what kind of currency exchange rate system the world should adopt after the war. Influenced heavily by its most prominent participant, John Maynard Keynes, countries decided to have all central banks buy and sell their own currencies so as to fix their currency in terms of U.S. dollars, with gold or U.S. dollars serving as reserves. Any country experiencing high inflation, and thus a balance of payments deficit, would under this system be subjected to an automatic harsh discipline: it would be forced to shrink its money supply, which would lower its inflation and thereby restore equilibrium in its international sector. The only exception was the United States, which could ignore its balance of payments deficits because it, and it alone, could print reserves—U.S. dollars—to cover any loss of reserves.

The conference also established the International Monetary Fund (IMF) to provide loans to countries having temporary difficulties dealing with balance of payments problems. It also created the International Bank for Reconstruction and Development, commonly called the World Bank, to make long-term loans to assist developing countries building infrastructure such as dams and roads.

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Which exchange rate system—fixed or flexible—is better? Both exchange rate systems have advantages and disadvantages, so that an answer to this question depends on the particular situation.

If every city in the United States had its own currency, economic activity and productivity in the United States would be severely curtailed. Commercial transactions involving firms in different cities would have currency-exchange-rate risks to contend with, people would have to bear costs of changing currencies every time they visited a different city, and long-term investment would be inhibited by exchange-rate uncertainty, for example. The same would be so, but to a lesser degree, if every state had its own currency, so there are tremendous benefits associated with having a common currency (a fixed exchange rate) among all U.S. cities and all U.S. states. The advantages of fixed exchange rates constitute the rationale behind the creation of a common currency in Europe.

Suppose, however, a fall in oil prices caused a major recession in Texas. Adjustment in Texas might take the form of an eventual fall in the wage of Texans, but primarily it would take the form of labor and capital moving out of Texas to other states. If Texas had its own currency, the adjustment could be facilitated by a fall in the value of the Texas currency, plus adoption of an appropriate Texas monetary policy. This is the advantage of flexible exchange rates: Flexing of the exchange rate and adoption of suitable monetary policy—neither possible under a fixed exchange rate (recall that under a fixed exchange rate an independent monetary policy is not possible)—can facilitate adjustment to recessions and booms.

There is a major difference between the Texas example and a world consisting of different countries, however. With different countries, labor and capital are usually not allowed to move across borders freely, suggesting that the main mechanism whereby Texas adjusts to its recession does not work across countries. This difference markedly increases the importance of having a flexible exchange rate across separate countries, and explains why within a single country it is advantageous to have a fixed exchange rate (a common currency), but across countries it is better to have a flexible exchange rate.

Unfortunately, exchange rates can flex for reasons other than the need to facilitate adjustment to recession or boom. History has shown exchange rates to be much more volatile than experts had predicted in 1971 when the world moved away from a predominantly fixed exchange rate system. As activity in financial assets markets has come to dominate the short-run determination of exchange rates, we have discovered that speculators can affect exchange rates dramatically, turning them from a stabilizing force into a destabilizing force. This possibility has caused central banks to modify the flexible exchange rate system by using monetary policy or direct intervention to stabilize exchange rates. In doing so, they must be careful to allow exchange rates to change to reflect fundamental forces—such as inflation-rate differences, productivity-growth-rate differences, and natural-resource discoveries.