Appraising Currency Strengths and Weaknesses: An Operational Model for Calculating Parity Exchange Rates
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*Robert M.Everett is Manager of Finance of General Electric, Venezuela. He holds an A.B. in Economics from Tufts University. **AbrahamM. George is President of MultinationalComputer Models, Inc., Montclair,NJ, an internationalfinancial consulting firm.He holds a Ph.D.in Business Administrationfrom New York University. ***AryehBlumberg is Professor of Finance at MontclairState College, NJ. He holds a Ph.D. in Economics from the University of Chicago. The authors would like to acknowledge helpful comments from the Journal's referees.
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FIGURE1 Parity Chart
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makers and managers. Accordingly, our choice of readily accessible proxies that correspond to the theoretical concepts is commensurate with the conclusions that we have drawn from our results. The final section summarizes the empirical evidence and discusses the implications of our analysis for forecasting exchange rates. The purpose of this section is to explain the derivation of the parity line. (Refer to THE Figure 1.) The horizontal axis measures time from a suitably chosen time origin. OPERATIONAL The vertical axis measures (1) the difference in the percentage change of the MODEL: purchasing power of currencies, and (2) the percentage change in the actual (ob- The Parity Chart served) exchange rate from the time origin. The parity line represents parity exchange rates over time; for example, at time ta the point P represents the percentage change in the parity rate from the time origin to, and hence enables us to calculate what the exchange rate ought to be according to our formulation of the purchasing power parity doctrine. Point A represents the corresponding percentage change in the actual (observed) exchange rate from the time origin. In a two-country model, the parity line is easily explained. For the purpose of theoretical exposition, let us assume a time origin that satisfies the condition of equilibrium-that is, purchasing power parity: two currencies, say dollars and marks, if adjusted for their respective units, command the "same" basket of goods.3 If the change in the purchasing power of country A's currency differs from that of country B's currency, the parity line will have a positive or negative slope, depending on the sign of the difference between changes in the purchas81 ing power of their respective currencies, as measured by a suitable price index.
When actual exchange rates are also plotted on the same chart, these observations should conform closely to the parity line. Consider next a world consisting of three countries: the United States, West Germany, and Japan. We now have three exchange rates, of which one is a cross-rate determined by the two other rates: dollar/mark,dollar/yen, and mark/yen.Ourobjective is to explain the determinants of the dollar/markrate, or, the number of U.S. cent
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