The purchasing power parity theory states that the equilibrium level of the nominal exchange rate as compared to its level in some base period can be calculated using the ratio of the domestic to the foreign price level compared to the level of that ratio in the same base period. The correspondence of the year-to-year percentage growth of the Mexican peso price of the U.S. dollar with the difference between the Mexican and U.S. inflation rates during the period here studied gives strong support to this hypothesis.
True or false?
The answer is False. It is true that the percentage devaluation of the peso correlates rather well with the excess of the Mexican over the U.S. inflation rates. But there are differences between these two series and they cumulate. The thing to look at is the Mexican real exchange rate with respect to the U.S. It can be expressed as
where Pmx and Pus are the Mexican and U.S. price levels and Π is the peso price of the U.S. dollar. The purchasing power parity theory claims that Q is a constant so that Π is proportional to Pmx/Pus. In fact Q varies quite substantially over the period studied as was shown in Figure 8.