International Finance: Putting Theory Into Practice

3.4. TRANSLATING FC FIGURES: NOMINAL RATES, PPP RATES, AND DEVIATIONS
FROM PPP 111

Figure 3.17:[Actual Rate]/[RPPPRate] against the usd, 1965=1.00

0

1

2

3

4

Jan-65Jan-67Jan-69Jan-71Jan-73Jan-75Jan-77Jan-79Jan-81Jan-83Jan-85Jan-87Jan-89Jan-91Jan-93Jan-95Jan-97Jan-99Jan-01Jan-03Jan-05

CPI* x S/CPI_us

DEM-EUR

JPY

GBP

SAR

THB

SourceUnderlying data are from Datastream

rate that keeps theRERat the same level as in the base period:

[RPPPrate vis-a-vist 0 ] =StRPPP,t^0 = St 0

1 +inflt 0 ,t

1 +infl∗t 0 ,t

; (3.17)

Relative Real Rate vis-a-vist 0 =

St

SRPPPt ,t^0

,

=

St

St 0

1 +infl∗t 0 ,t

1 +inflt 0 ,t

, (3.18)

which is unity plus the change in the real rate except that we use each country’sCPI
inflation (or some similar index) rather than the change in the absolute price of an
internationally common basket. In pre-eurdays, theECoreuministers ofEMR^18
countries used theRPPPnorm when devaluations were negotiated. They went back
to the time of the last re-alignment, and corrected that base-period level for the
accumulated inflation differential since then, as in Equation [3.17]. But the main
use of theRPPPfor business is that it tells us whether a country has become cheaper,
or more expensive, relative to another one. Cheapening countries are good if they
are your production centers or your favorite holiday resort, but bad if they are the

(^18) Exchange Rate Mechanism—the arrangement that kept members’ crossrates stable. See Chap-
ter 2.