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One proposal to stabilizethe international monetary system involves setting exchange rates at theirpurchasing power parity rates. Once exchange rates are correctly aligned(according to PPP), each nation would adjust its monetary policy so as tomaintain them. What problems might arise from using the PPP rate as a guide tothe equilibrium exchange rate?
Answer. The proposal to adjust monetary policy so as to maintainpurchasing power parity assumes that the PPP rate is the equilibrium rate. Thisassumption ignores the many shortcomings of PPP as a theory of exchange ratedetermination. Deviations from PPP have prevailed throughout the history offloating rate regimes. Thus there is good reason to believe that PPP provides apoor proxy for the equilibrium exchange rate at any point in time. If the PPPbenchmark is used as a proxy for the equilibrium exchange rate when there areequilibrium departures from PPP, this guideline will interfere with long‑runequilibration in the foreign exchange market. Here is the basic problem:Domestic and foreign goods are not perfect substitutes, and hence issues ofspatial arbitrage and the law of one price are irrelevant. Imagine that at thePPP exchange rate U.S. firms can't find buyers for their goods, while Japanesefirms work overtime to meet the demand for their goods. Something will have togive, probably the real exchange rate. When a country opens new markets,introduces new products, or experiences a favorable or unfavorable price shockfor its traditional exports, the real exchange rate will change. Monetarypolicy that stabilizes a disequilibrium exchange rate is clearly inappropriate.
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