Survey_GK_2015

Abstract

We start by proposing the simplest possible model for the exchange rate under floating. Let denote the logarithm of the USD/Sterling exchange rate and the relative price level between the US and the UK. These variable are assumed to be non-stationary but integrated of order 1, I(1). If Purchasing Power Parity (PPP) held in the long run, the two time series would be cointegrated. In this section we show the monthly data for our analysis and provide the unit root analysis for the exchange rate and the relative price level. Besides the wholesale price indices (WPIs) we consider the consumer price indices (CPIs) as alternative measure of prices in the UK and the US. Figure 1 shows the logarithms of the three series from January 1919 to April 1925. Until March 20 1919 the pound was pegged at an overvalued rate of 4.76 and this policy was supported by restrictions on international money, capital and gold movements. The official support of the exchange rate ceased and the restrictions were lifted during the following months (Moggridge, 1969, p. 14). Accordingly we see a strong initial depreciation of the pound despite an increase of the relative price level in the second quarter of 1919. Subsequently, we see a long run co-movement of the exchange rate and relative prices onwards, which seems to be more pronounced for the WPI than the CPI. We note a period of a slightly lower US inflation rate until the end of 1920 which was then followed by four years with considerably lower British trend inflation. Given the end of the official support for the exchange rate in April 1919, we consider the sample from April 1919 early summer to April 1925.