Large-scale wars typically bring a suspension of international trading and finan

Question

Large-scale wars typically bring a suspension of international trading and financial activities. Exchange rates lose much of their relevance under these conditions, but once the war is over, governments wishing to fix exchange rates face the problem of deciding what the new rates should be. The PPP theory has often been applied to this problem of postwar exchange rate realignment. Imagine that you are a British Chancellor of the Exchequer and that World War I has just ended. Explain how you would figure out the dollar/pound exchange rate implied by PPP. When might it be a bad idea to use the PPP theory in this way?

Explanation / Answer

Let us consider a good X.

Assume that, price of X in Great Britain is 10 GBP.

Also assume, price of X in US is $18.

Then, as PPP states, that the price of the same good will be the same in different countries, adjusted for exchange rate:

Dollar/Pound exchange rate implied by PPP is 0.5556 Pound per dollar.

However, this way of determining exchange rate using PPP can be erroneous due to following reasons.

(a) PPP assumes costless global transaction which is incorrect.

(b) It is assumed that there exists complete free trade and no capital/exchange-rate controls.

(c) Post-war political and economic instability will hinder PPP.

(d) Exchange rate is not determined solely by relative price of a good in 2 countries, it has many other economic variables. Determining exchange rate while ignoring all these determinants will be a myopic vision.

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