Chapter 45

Examining China: Purchasing Power Parity, Terms of Trade, and Real Exchange Rates


Under a fixed exchange rate system, purchasing power parity (PPP) tells us that the inflation rate for the traded commodities will converge across countries. In contrast, the adjustment for the PPP violations is a bit different. As the exchange rate is fixed and the inflation rates tend to converge, the terms of trade effect, that is, the relative price change of nontraded relative to traded goods lead to deviations in the domestic inflation rate from the PPP rate. The terms of trade adjustments are not unique to China. Under a floating exchange rate combined with a domestic price rule, the exchange rate will reflect the relative price changes. ...

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