Paul Krugman
ABSTRACT
differences in growth rates among countries would give rise to strong secular
trends in real exchange rates; for example, fast-growing countries might need
high income elasticities of demand for their exports, while having low income
elasticities of import demand. The net effect of this relationship between
are much smaller than one might otherwise have expected: relative PPP holds
fairly well. This paper documents the existence of a "45-degree rule", and
entiation.
Paul Erugman
Department of Economics, MIT
Cambridge, MA 02139
What determines equilibrium real exchange rates? In the
runs.
1
is that the apparent income
The cnrical regularity
of growth.
systematically related to the country's long tern rate
new point here is that in order to explain the 45-degree rule with
its implication that there are not strong trends in real exchange
2
rates, it is necessary to suppose that there is not much
advantage trade.
equilibrium real exchange rates over time. The second part reviews
less real exchange rate movement over time than one would have
3
A1tht much theoretical literature in international
4
*
x — x(y ,r) (1)
price of imports:
m m(y,r) (2)
*
B — px -
ep m (3)
— p[x -
rm]
b — x-rm (4)
5
Let
db/dt — x[cy* + -
'm' + (l-e)r] (5)
A A
- + (e+e-l)r — 0 (6)
6
-
we
may have different long term rates of growth. More generally,
*
xm (8)
7
has bean Thus there must be scching systematic about the
the US and the UK faced the reverse. While Houthakker and Magee
did of course notice that Japan was the fastest growing country in
their sample, while the US and the UK were the slowest, they did
8
results for
presents the Houthakker-Magee income elasticity
but I was not able to reconstruct the "foreign" growth for the
data below
Houthakker-Magee sample. In the analysis of post-1970
9
In this rsion we see that on average, if country A grew twice
power parity hold much better than one would have expected if one
export elasticity and low import elasticity took care of that. One
--
growth rate by a secular appreciation of its real exchange rate
explanations.
10
3. Explaining apparent income elasticity differences
occur if a
exchange rate change over time. The same result would
the
necessary to grow faster than the relative rate dictated by
income elasticities.
countries face.
11
income determine economic growth, rather than the
productivity growth.
curve for exports for each country will not help: as a country
grows, its supply curve will shift out, but this will simply move
this; but this seems unlikely to explain the basic stylized fact
12
need for trend shifts in real exchange rates.
were the US and the UK. Japan was clearly playing catch-up with
the rest of the industrial world, which meant that it was becoming
13
goods bw:: omparative disadvantage in capital-intensive goods.
that its growth would be biased toward the sectors in which it did
and could explain why Japan did not need declining terms of trade.
Conversely, the US and the UK were being caught up to: the world
was becoming more similar to them, which would other things equal
countries, but not why they are favorable to almost precisely the
14
Second, this story has an implication about the shares of trade in
income. Suppose that an economy grows, while the rest of the world
economy must become more closed over time. Admittedly this result
developments (or more to the point, the lack of them) in the 1950s
and l960s.
over time. As we will see, however, the 45-degree rule has on the
whole been stable over time, persisting in the 1970s and 1980s
15
inspired t: Tok for more unusual explanations.
obtain among industrial countries over the long run? The answer, I
nations are basically all pretty much the same. Germany and the US
can produce pretty much the same things, and produce them about
far off those in the other for an extended period, all production
But if Germany and the US are pretty much alike why do they
16
than comparative advantage.
imports are not really fixed sets of goods, but instead aggregates
whose definitions change over time as more goods are added to the
international trade.
17
monopoiit: :impetition. We suppose that there are two countries,
Home and Foreign, and that each can produce and consume any of an
which enter the model through the assumption that the labor
3
I ignore the question of how consumption is allocate
18
required to produce a good involves a fixed cost:
1. —
1
a + x.1 for all i (11)
L—Xl. (12)
demand
— l/(l-9) (13)
19
Given tHs elasticity of demand, each firm will charge a
x(p/w -
) — a (15)
> x — aO/fl(l-O)
and
1 — a/(l-9) (16)
n — L(l-8)/a (17)
20
*
forces L and L If transport costs may be neglected these
* * * * *
n )
= L/(L+L ) on Home goods, a fraction n /(n+n*) L /(L±L ) on
Foreign goods.
representative product is
*
M — [n/(n+n )]y (19)
* * *
X — [n /(n+n )]y (20)
21
Now consider what happens if the Home and foreign economies
note that even if the labor forces grow at different rates, the
A A A * * A* *
X — M y[y /(y+y )] + y [y/(y+y )] (21)
AA* AA* * *
+
*
—
X/y — (y/y )[y /(y+y )] y/(y+y ) (22)
22
and similarly an apparent income elasticity of import demand equal
to
* * *
— M/y —y /(y+y ) + (y /y){y/(y+y )J (23)
We note immediately from (22) and (23) that the higher the
23
basically alike, then the prices of their typical traded outputs
45-degree rule. Thus our next step must be to examine the validity
annual data for the period 1971-1986. The dependent variables are
fri
= manufacturesimports in 1982 prices
24
The explanatory variables are
at a time, they might suggest the need for more careful cleaning
UK, whose import equation refuses to make sense; I have not been
able to resolve this puzzle, and will drop the UK from subsequent
discussion.
25
What we may note, however, is that there is still, as in the
confidence:
.'
26
l970s and l9SOs there was a general convergence of growth rates.
European growth rates decline more than those of the US, so that
though still fast growing, was not as far out of line as before,
Conclusions
long term trends in real exchange rates is their absence. That is,
over the long run relative purchasing power parity for the
27
income elasticities of import demand, with the result being that
links the long run to the short and medium run dynamics in which
a
the conventional income-and-price-elasticityframework remains
28
crucial tool. However, if the paper draws attention to what I
29
Table 1: Income elasticities and growth rates j l950s and
Count] Coefficients
Y
* RXP RXP ( -1)
________ SEE R2
Country Coefficients
Y RNP RMP(-l)
in parentheses.
Table 4: Income Elasticities and Growth Rates. 19!
> 2.4
2.2-
tJ
0
2-
L 1.8-
o
10
in
Bhagwati (1969): "International trade and economic expansion",
297-308.
51:111-125.
1
and the
Krugman (1980): "Scale economies, product differentiation,