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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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2.3 Real Models of the Real Exchange Rate

Most real models of the exchange rate focus on real—as opposed to nominal—determinants of the price-level-adjusted exchange rate. PPP is a particularly simple version, where the real exchange rate is assumed to be constant. The second portion of the section describes two other approaches to modeling the real exchange rate; the first of these two approaches is associated with the Balassa–Samuelson framework, but more generally allows for the presence of nontradable goods. The second of these approaches encompasses the general equilibrium models of the exchange rate arose in response to the ad hoc nature of the extant models of the 1970s. In this sense, they represent the open economy analog to the rejection of ad hoc macroeconomic models dominant in the domestic context.

2.3.1 PURCHASING POWER PARITY

PPP is one of the most important concepts in international finance. Several excellent surveys exist on the subject, including Breuer (1994); Rogoff (1996), and Taylor and Taylor (2004). While a thoroughgoing discussion of PPP is beyond the scope of this chapter, some discussion of PPP is necessary to set the stage for a discussion of real exchange-rate determination.16 The simplest statement of PPP is that the common currency price of an identical bundle of goods is equalized:

2.15 2.15

where p corresponds to the price of a bundle of goods.

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