Tuesday, October 23, 2012

Matias Vernengo — What's the deal with PPP?

It is obvious that there are 'imperfections' and the natural rate of interest is not equalized in the real world, so the exchange rate also deviate from the natural rate. But that isn't the main problem with the mainstream view. As we saw, the capital debates undermine the theoretical basis for a natural rate of interest, and hence for a natural exchange rate (or a natural rate of unemployment for that matter). Hence, it is the Keynesian (and Sraffian) institutional rate of interest, as determined by monetary authorities that rules the roost. The conventional rate of interest is then connected to a conventional exchange rate [ther institutional factors become relevant, like the existence or not of capital controls, etc.].

Leave aside the theoretical problems of purchasing power parity measures, since they are NOT attractors of the actual exchange rates [the reasons why Argentina had a 1 to 1 exchange rate with the dollar for a decade, or Greece has a 'fixed' parity too are political and institutional], and even if for some purposes you may want to use PPP rates as a measure of material welfare, one may also be interested in actual market exchange rates for other purposes. Indeed, for most of the relevant matters that concern economic well being, particularly in peripheral countries, like the capacity to repay foreign debt and avoid default and import capital goods to promote growth, it is the market exchange rate that is central to convert incomes in different countries into a common numeraire.
Naked Keynesianism
What's the deal with PPP?
Matias Vernengo | Associate Professor, University of Utah

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