THE REAL VALUE OF CURRENCIES
When the dollar slumped against the yen this spring, debate was reignited in Washington and Tokyo over the question of what constituted the "correct" exchange rate. One touchstone popular with economists is purchasing power parity (PPP)--the rate that balances the cost of living in, say, Osaka and Chicago.
Trouble is, PPP hasn't worked well as a predictor. Most PPP calculations suggest that the dollar should be worth 110 to 120 yen--far stronger than its current 87-yen value. Even in simpler days, PPP may not have been reliable. When Harvard University economist Kenneth A. Froot and two co-authors examined English and Dutch grain, dairy, and silver prices over a 700-year span, they found that PPP was violated as mften as maintained. Indeed, despite all the changes in trade and financial technology, "the volatility of deviations...has been no larger in the 20th century than it was in the 14th," the economists concluded.BY MIKE McNAMEE