Chapter 15

Exchange Rates, Devaluations, and the Terms of Trade


The nominal exchange rate is only the appropriate measure of the real exchange rate or terms of trade when the Consumer Price Index (CPI) remains unchanged. The nominal exchange rate and real exchange rate provide the same signal only if the CPI changes do not offset the nominal exchange rates. Our theory suggests a simple testable implication. When the real and nominal exchange rates diverge, the terms of trade or real exchange rate provides the correct signal.

The methodology for adjusting for the cost of living has been popularized by The Economist in its famous Big Mac standard. The magazine reported in the back of its issues the price of a Big Mac in local currency converted ...

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