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Purchasing- An alert reader of this book

, might ask: Why are we develop-

Power Panty as ing a theory of the exchange a Special Case rate here? Didn't we already do that in the preceding chapter?

As you may recall, the preceding chapter developed a theory of the exchange rate called purchasing-power parity. This theory asserts that a dollar (or any other currency) must buy the same quantity of goods and services in every country. As a result, the real exchange rate is fixed, and all changes in the nominal exchange rate between two currencies reflect changes in the price levels in the two countries.

The model of the exchange rate developed here is related to the theory of purchasing-power parity. According to the theory of purchasing-power parity, international trade responds quickly to international price differences. If goods were cheaper in one country than in another, they would be exported from the first country and imported into the second until the price difference disappeared. In other words, the theory of purchasing-power parity assumes that net exports are highly responsive to small changes in the real exchange rate. If net exports were in fact so responsive, the demand curve in Figure 30-2 would be horizontal.

Thus, the theory of purchasing-power parity can be viewed as a special case of the model considered here. In that special case, the demand curve for foreign-currency exchange, rather than being downward sloping, is horizontal at the level of the real exchange rate that ensures parity of purchasing power at home and abroad. That special case is a good place to start when studying exchange rates, but it is far from the end of the story.

This chapter, therefore, concentrates on the more realistic case in which the demand curve for foreign-currency exchange is downward sloping. This allows for the possibility that the real exchange rate changes over time, as in fact it sometimes does in the real world.

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