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PPP and Floating Eschange rates

Nominal exchange rate: e=e/$1

Real exchange rate RER=e*Pus/Puk. Basic prediction about PPP is that if e is left free to float, then proprotional rate of change of e =UK inflation-USA inflation.

Real exchange rate should remain more or less constant.

If UK inflation is always bigger than USA:

The case for flexible exchange rate.

Bretton Wood system was going on for 5 years before Friedman finnished the essay. Most were happy about that and Friedman was only one not happy. BW - e rates occasionally adjustable (when in fundamental disequilibrium). It happen when internal balance (trade balance on current account) with external balance. This was understandable as capital flows were much smaller.

Suppose ther is a sudden dcline in the demand for UK exports. Then UK will have an incipient BoP deficit. X-M<0. Under the BW system this incipient deficit would turn into an actual deficit. The economy would run into a deficit on trade balance. Under floating this can't happen, because sterling will depriciate by an amount sufficient to maintain BoP equilibrium. Depriciation of sterling=rise in e. The need for worring about the e would be elliminated if money wages and prices in a country would be flexible. Then P and W would be the shock absorbers.

Friedman did not mention Marshal learner condition and elasticities. And no mention of PPP theory. Friedman said the speculation would be stabilising under flexible e, but not under BW. Speculation destabilises under quasi fixed rates because e.g. in Britain 67 had experienced inflation more than that of trade partners. Cummulatiive effect was to render sterling uncompetitive. Then speculators would change their portfolio and ass govn can't run down their foreign exchange reserves indefinitely.

Under floating:

At time we assume that e is at A, but wonders to B. It is now undervalued a, it has depreciated by too much. Speculators will reaalise this and go to e'. PPP line is the centre of gravity.

Experience has not confirmed that.

There were persistnet misalignments of some currencies. There is no consensus why exchange rate is not medium term at PPP, only a long term.

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