Purchasing Power Parity and the

Yen/Dollar Exchange Rate

Gunther Schnabl

1. INTRODUCTION

T HE situation on the global currency markets as observed in 1999 and 2000

is contradictory. Japan and Euro-land show different correlations between
economic growth and exchange rates. While the Yen proved impressively strong
against the Dollar, the Euro has fallen consistently since its introduction in
January 1999. The steady decline of the European currency is explained by two
central factors; the weak economic dynamics of the central Euro countries in
comparison with the US, and structural problems such as those in the labour
markets. Japan in contrast, whose economy was even weaker and much more
regulated than in Europe, suffers under a strong Yen. Observers speak of a
paradoxical constellation of a weak economy and a strong currency.
This paper explains why the Yen has remained persistently strong since the
beginning of the 1980s, and why even in the economic downturn of the 1990s this
trend was not reversed. Since 1980 the Japanese Yen has significantly
appreciated against the Dollar. Where the US Dollar was worth 226 Yen in
1980, in the summer of the year 2000 the Dollar was traded for around 107 Yen.
This corresponds to a nominal appreciation of more than 50 per cent. Although it
is generally assumed that a weak economy (as in the case of the Euro) favours
capital exports and depreciation, the Yen’s appreciation in the 1980s also
continued through the deep recession of the 1990s, when the Yen gained 26 per
cent in value against the Dollar.
The failure of capital flows as an explanation for the strong Yen suggests a
need for an alternative approach, such as purchasing power parity, which uses
relative prices as the determinant of exchange rates. In this paper the appreciation
of the Yen will be explained on the basis of the relative version of purchasing
power parity. After an introduction to the concepts and measurements of
purchasing power parity (Section 2) it will be shown that the results of regression

GUNTHER SCHNABL is from Tübingen University. He is grateful to Dirk Baur and two
anonymous referees for their very helpful comments.

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and 350 Main Street, Malden, MA 02148, USA. 31
32 GUNTHER SCHNABL

analysis are particularly significant when based on export prices instead of

broader price indices such as consumer or wholesale prices (Section 3).
Furthermore, it will be shown that if the exchange rate is deducted from relative
prices, the enterprises’ price behaviour in international markets is especially
interesting. The price-setting instruments and the shifting behaviour of the
Japanese export industry as determinants of the exchange rate will be analysed in
Section 4. Conclusions will be drawn in Section 5.

2. PURCHASING POWER PARITY: CONCEPTS AND MEASUREMENT

There are primarily two main theories explaining the movements of exchange
rates: one focusing on interest rates and international capital movements, the
other focusing on prices and international trade. The basic conflict between the
two approaches lies in the perceived time frame. Approaches relying on
international capital movement are short term because they assume constant
prices – being grounded in Keynesian thought. The purchasing power parity
(PPP) theory on the contrary, which assumes price flexibility, can be regarded as
being long term.
The separation of the two theories according to their respective time frames
means that in the short run, due to the high mobility of international capital flows
and sticky prices, the exchange rate is determined through capital movements.
Nominal exchange rate movements lead to real exchange rate movements due to
short-term price rigidities. In the long run however, prices adapt and influence the
exchange rate (Krugman, 1978, p. 397; and Rogoff, 1996, p. 658). This points to
purchasing power parity as the most adequate approach to explain exchange rates
over the long term. The question in this case is what the perceived time frame for
the adaptation of the exchange rate to prices would be.
In its general form the purchasing power parity theory suggests that the
exchange rate of two currencies will – over any period of time – be determined by
the price levels of the two countries (absolute purchasing power parity) (Cassel,
1916, p. 62). The purchasing power parity goes back to David Hume’s law of one
price: In markets without transport costs and trade impediments, a homogenous
product will be traded on different markets under consideration of the exchange
rate (e) at the same price due to arbitrage movements. The following equation
applies for the price (pi) of the product i:1
pi ˆ e
pi : …1†
Under the assumption of perfect competition the law of one price leads to
absolute purchasing power parity. A domestic price index can be represented as:
1
* marks the variable of the other country.

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P ˆ f …p1 ; p2 ; . . . ; pn † and a foreign price index as: P ˆ f …p1 ; p2 ; . . . ; pn †. If

the law of one price applies to all of the products in the two countries, and if the
goods enter each country’s consumer price index with the same weights, the law
of one price applies to a single product as well as aggregate price levels (P)
(Dornbusch, 1987, p. 1075).
There is a controversy over the mechanism through which the general price
level adjusts by way of the exchange rate. On the one side the law of one price,
and with it the arbitrage movements of traded goods, is central. On the other side,
monetarists point to the general price level, which is determined by supply and
demand on the money market as the central mechanisms (Frenkel, 1976, pp. 201–
4). Both approaches assume flexible prices and full employment, in contrast to
the Keynesian short-term approach. In both cases the exchange rate results from
the relative price level of two countries (absolute purchasing power parity):
P
eˆ : …2†
P
In practice however, the absolute version of purchasing power parity has not
been used much empirically. The absolute purchasing power parity is hard to
measure, because identical standardised baskets of goods in different countries
don’t exist (Hinkle and Nsengiyumva, 1999, p. 73). The derivation of the
purchasing power parity from the law of one price through the aggregation of the
single product’s prices requires that the goods have the same weights in the
respective consumer price indices. Since consumption habits are different in each
country, and with them the weights in the price indices, deviations simply arise
from different methodologies. Furthermore, all kind of barriers to trade such as
transportation costs, tariffs and non-tariff barriers cause different prices for the
same commodity in different places.
Nevertheless, trade impediments don’t necessarily indicate that arbitrage
doesn’t work and prices in different locations aren’t closely related. Even if prices
are not (totally) equalised because of imperfect competition, it is possible that an
increase in the domestic price level in comparison to that abroad implies a
proportionate depreciation of the home currency. This relationship between
changes in exchange rates and changes of the price level in two countries is
expressed by the relative version of purchasing power parity, which says that
changes in exchange rate2 equal the difference in changes in the price levels of
two countries:
^ÿP
^e ˆ P ^ : …3†
The bulk of the empirical literature focuses on testing the relative version of
the purchasing power parity, because it allows methodical problems of
2
^ indicates change rates.

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measurement and problems caused by all kind of trade barriers to be

circumvented. Unfortunately, the empirical tests, which have relied mostly on
consumer prices,3 haven’t found much support for the relative version of PPP
either. The formal econometric tests mainly reject relative PPP (Froot and
Rogoff, 1995, pp. 1650–72). Samuelson (1964, p. 153) judged that:
unless very sophisticated indeed, purchasing power parity is a misleading pretentious doctrine,
promising us what is rare in economics, detailed numerical predictions.

Samuelson’s statement can also be regarded as true for the Yen-Dollar

exchange rate. A look at the purchasing power parity based on consumer prices as
indicated in Figure 1 supports his view.4 The Yen-Dollar exchange rate shows the
same trend as the purchasing power parity, but a clear correlation is not
recognisable. The Yen exchange rate was more volatile and the Yen appreciated
more against the Dollar within the observation period than PPP based on

FIGURE 1
Exchange rate Yen/Dollar and PPP (based on consumer prices)

Source: IMF (various issues): International Financial Statistics (exchange rates as period averages).

3
Consumer price indices are readily available for representative baskets of goods for most
countries (Hinkle and Nsengiyumva, 1999, p. 74).
4
The data cover the time period from 1980 to 1999. The time series starts in the 1980s, since the
Japanese international capital flows were liberalised in this period and market forces on the
international asset markets could work more efficiently. The selected observation period has also
the advantage that it starts before the Reaganomics caused major disturbances in the international
currency markets.

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consumer prices would have predicted. The assumption of monetarists that the
exchange rate can be explained through changes in money supply and demand
alone (and thus through the change in general price levels in the two countries) is
proven wrong. The lower inflation rates recorded in Japan can only partly explain
the Yen appreciation within the observation period.
There are different explanations for the deviation of the exchange rate from the
relative purchasing power parity.5 Monetarist models explain the deviations of
the purchasing power parity from the exchange rate by price rigidity. In the long
run, prices would converge and the general price levels of two countries would
adjust towards each other (Kravis and Lipsey, 1978, pp. 195–97).6
In contradiction to purely monetarist models, Balassa (1964) and Samuelson
(1964) distinguish between traded and non-traded goods, and find a structural
deviation of the exchange rate from the purchasing power parity possible.7 They
explain this phenomenon with trade restrictions. Balassa and Samuelson assume a
Ricardian two-country model with labour as the single production factor, as well
as a constant input coefficient and perfect competition. In both countries both a
tradable and non-tradable good is produced.8
The prices of tradable goods in different markets will adjust by way of the
exchange rate if there are no trade restrictions or transportation costs. Under the
assumption of the Ricardian model that prices are equal to marginal wage costs,
different productivity levels would result in different wages. If the productivity in
the production of tradable goods increases, the wages in this sector will also
increase. Because the production factor labour is mobile within a country, the
wage for the production of non-tradables increases as well. However, since there
is no productivity increase in the production of non-tradable goods behind the
wage increase within the sector, the price of the non-tradables must increase in
comparison with the tradables.
The result of this phenomenon is that the price level of non-tradables increases
in comparison to the price level of tradables. Since the consumer price index of a
country includes both tradables and non-tradables, this price index will increase
faster than the price index of the traded goods alone. PPP, which is based on the
general price indices, deviates from the equilibrium exchange rate, which itself is

5
Dornbusch (1987, pp. 1078–79) gives an overview.
6
The monetarist assumptions are based on the homogeneity postulate. This states that a purely
monetary disturbance leaves the equilibrium relative prices unchanged. The real money supply, all
prices and the exchange rate change proportionally.
7
Monetarist models which acknowledge that the law of one price applies only to tradable goods,
would assume that in the long run the price levels of tradable and non-tradable goods would adjust
through substitution relationships reversing the deviation from PPP.
8
In practice, simplified industrial goods are classified as tradables and services are classified as
non-tradables, even when the distinction is not so clear (DeGregorio, Giovannini and Wolf, 1994,
pp. 1231–32). For the difficulties of differentiating the two groups of goods see Kravis and Lipsey
(1978, pp. 201–2).

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determined on the basis of arbitrage through the price competition of tradable

goods.
The greater the discrepancy in productivity between the production of tradable
and non-tradable goods, and the greater the discrepancy in price between the two
types of goods, the larger the gap between the equilibrium exchange rate and the
general PPP. When the productivity of tradable goods increases faster and the
domestic prices sink more rapidly than those of foreign competitors, the real
exchange rate appreciates.
From the assumption that the prices of traded goods adjust themselves over the
exchange rate, Balassa implies that an approximation of the exchange rate by PPP
can only fit when the calculation is based exclusively on a price index of traded
goods. Pigou (1920) and Viner (1937) had already called for this stipulation.
In Figure 2 the purchasing power parity of the Yen against the Dollar and DM
was calculated according to Pigou and Viner on the basis of the respective
wholesale and export prices of Japan and the US. Wholesale price indices are
usually more heavily weighted with traded goods and underweighted with non-
traded goods, whereas the export price indices only include traded goods.
According to Balassa and Samuelson, we would expect that the smaller the
share of traded goods, the smaller the price distortions in the target markets,
which arise through import impediments or cost shares of local services in the

FIGURE 2
Exchange Rate and PPP (based on consumer, wholesale, export prices)

Source: IMF (various issues): International Financial Statistics.

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retail price. This would raise the expectation that the deviation of the exchange
rate from PPP would be highest if PPP is based on consumer prices, and lowest if
it is based on export prices. A concept based on wholesale prices would lie
somewhere in between.
This assumption is confirmed by Figure 2, which shows the exchange rate of
the Yen against the Dollar in comparison to different concepts of PPP. As
expected, PPP calculated on the basis of export prices delivers the best result,
showing a strong correlation between the exchange rate and relative export
prices. This is especially true for the time period after 1985. Since the
appreciation of the Yen after the Plaza Agreement, the exchange rate and the
relation of the Japanese export prices to those in the US have to a large degree
developed parallel to each other.9

3. EMPIRICAL APPLICATION FOR THE JAPANESE YEN

Figure 2 suggests that the selection of the appropriate price index could have
significant influence on the approximation of the exchange rate by relative
purchasing power parity. The more traded, or fewer non-traded goods, are
included in the price index, the better the approximation of the exchange rate by
PPP would be.
In this section the results of a simple two-variable regression analysis on the
correlation of prices and exchange rate are presented. The test includes three
different price indices as reported by IMF International Financial Statistics: The
consumer price index as general price index,10 a price index for industrial goods
as represented by the wholesale price index of Japan and the producer price index
of the US, and an export price index which only includes traded goods. For the
Yen/Dollar exchange rate IMF period averages were chosen.
The analysis uses quarterly data, which clearly reduces the results for
correlation coefficients in comparison to an analysis based on annual data. One
reason for this could be that the volatility of exchange rate movements (random
walk) is reduced significantly, if annual data are used. The significance of the -
values doesn’t change significantly, however, if annual data replace the monthly
data.
9
The continuing weakness of the Yen in the first half of the 1980s is often seen as a speculative
bubble. The devaluation of the Yen in the early ’80s was maintained longer as reflected by the
economic fundamentals. Krugman (1985, p. 4) had already commented on this phenomenon before
the Plaza Agreement: ‘Almost nobody who has seriously studied the issue believes that the US real
exchange rate can remain indefinitely at its present level.’ In this case, the interventions of the
central banks in favour of a weaker Dollar were successful because they favoured a development
which would have taken place anyway.
10
If the GDP deflator is used as general price index the results are very similar.

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According to the assumptions of relative purchasing power parity (equation

(3)), the difference between the rates of change of the respective price levels in
the two countries (exogenous variable X) is regressed against the change rate of
the Yen/Dollar exchange rate (endogenous variable Y). Using change rates has
the advantage that the question of which base year would be adequate to use can
be avoided.
The results of the regression analysis are listed in Table 1. They support the
analysis made in Section 2 by Figure 2. There is no sign of a correlation between
the Yen/Dollar exchange rate and relative PPP based on consumer prices. If
wholesale prices are used, the correlation coefficients improve (R 2 ˆ 0:278
(quarterly data)/R 2 ˆ 0:476 (annual data)), and the -value is significantly
different from zero at a one per cent level. The test made on the basis of export
prices shows impressive results. The correlation coefficient over the total
observation period amounts to 0.64 (quarterly data) and 0.90 (annual data)
proving a close correlation of both variables. The -value is significantly
different from zero at a one per cent level. t-Statistics mount to a value of 11.76.
The regression analysis therefore strongly supports the assumption that the
export pricing behaviour of Japanese and American enterprises is a central
determinant for the explanation of the Yen/Dollar exchange rate. This fact also
explains the Yen’s strength in the 1990s. When the domestic demand stagnated
because of the deep recession, Japanese international enterprises had to reduce
prices abroad in order to stabilise their sales volume. The sinking prices in the
exports markets brought the Japanese currency under appreciation pressure.

TABLE 1
Regressions of Relative PPP (X) on the Yen/Dollar (Y) Exchange Rate: Y ˆ  ‡ X
^ Japan ÿ P
Y ˆ ^eYen=Dollar ; X ˆ P ^ US  (interception)  R2
(standard error) (standard error) {annual data}
[t-statistics] [t-statistics]

PPP based on consumer prices ÿ0.015 ÿ1.366 0.030

(0.008) (0.880) {0.001}
[ÿ1.963] [ÿ0.153]

PPP based on wholesale prices 0.010 2.346*** 0.278

(0.006) (0.431) {0.476}
[1.577] [5.439]

PPP based on export prices 0.006 1.228*** 0.642

(0.004) (0.104) {0.900}
[1.454] [11.759]
Notes:
Regression based rates of change.
*** Significantly different from zero at a one per cent level.
** Significantly different from zero at a five per cent level.
* Significantly different from zero at a ten per cent level.

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4. INTERNATIONAL PRICE SETTING AS A DETERMINANT OF THE EXCHANGE RATE

The results of the regression analysis in Section 3 support Balassa’s and

Samuelson’s view that the real appreciation of a currency is caused by the price
level of tradables remaining lower or increasing more slowly than that of non-
tradable goods. On the international markets competition is high. International
enterprises have to adjust their prices and increase productivity. In closed
domestic markets however, the number of competitors is fewer and competition
limited. Prices can rise faster and productivity increases more slowly.
The empirical analysis of the price discrepancies between tradable and non-
tradable goods in individual countries supports this assumption. DeGregorio,
Giovannini and Wolf (1994) examined the price development of tradable and
non-tradable goods in 14 OECD countries between 1970 and 1985. The prices of
the predominantly non-tradables within the service sector increased faster in 13
countries than did the prices of tradable industrial goods. The relative price of
non-tradables to tradables increased on average by more than one per cent per
year.
This development is particularly distinctive in Japan. In the inquiry conducted
by DeGregorio, Giovannini and Wolf, Japan shows the highest price difference
by far. The price indices of the non-tradable goods clearly rose faster than that of
the tradables. While the prices of Japanese exports have significantly decreased,
the domestic prices have risen. The price increases are especially significant for
non-tradable goods such as services and agrarian goods.11 The prices climbed by
more than 50 per cent in the service sector while they fell by more than 30 per
cent in the export sector (domestic currency) (Figure 3).
The discrepancy in price development for the Japanese domestic and export
sectors suggests considerable differences in efficiency and competitive
preconditions. While the Japanese export enterprises compete on the highly
competitive international markets, competition in the domestic sector is
restricted.
The Japanese Economic Planning Agency (1994, pp. 363–67) estimates that in
1990 more than 42 per cent of the Japanese economy was regulated on the basis
of net output. Although the Japanese industry can be considered to be quite
deregulated (value 14.1 per cent), the percentage of regulation in other sectors
reach 87 to 100 per cent; such as agriculture, mining, construction, financing,
transportation, communication and public utility.12

11
Japan maintains substantial trade impediments for agrarian products.
12
It is difficult to measure and record the exact degree of regulation. The Economic Planning
Agency considers an economic sector as regulated if at least one competition restricting regulation
is established.

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40 GUNTHER SCHNABL

FIGURE 3
Sectoral Price Indices (Japan)

Source: Bank of Japan (various issues): Economic Statistics Annual.

As a direct consequence of the regulations, the general price level in Japan has
increased against export prices. Numerous studies and press releases support the
conclusion that the general price level in Japan is distinctly higher than in other
industrialised countries. According to the OECD’s Main Economic Indicators
(1998, p. 224), the consumer prices in Japan are 47 per cent higher than in the US
and 32 per cent higher than in Germany.13
The difference between domestic and export prices explains the structural
deviation of the purchasing power parity from the exchange rate of the Japanese
Yen. The price strategies of Japanese export industries were a central factor in
this development. While the export prices of US and German exporters have
continually risen since the early 1980s, the Japanese exporters have clearly
reduced their prices (Figure 4).
Two questions arise from this unequal price development in the export markets
of the most important industrialised countries: Why did the Japanese producers
pursue a different price strategy than their foreign competitors, and how could the
Japanese export enterprises reduce their prices to such an extent?
The falling prices in the Japanese export sector can be explained by the
appreciation of the Yen. All else being equal, the appreciation of the domestic

13
Calculated on the basis of consumer price indices and the exchange rate.

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FIGURE 4
Export Prices in International Comparison (domestic currency)

Source: IMF (various issues): International Financial Statistics.

currency makes export goods more expensive abroad. According to the elasticity
approach of the exchange rate theory, if the demand is price elastic sales abroad
will fall, but in the case of Japanese exports, the expected decrease in the trade
surplus did not take place. The level of the Japanese trade surplus remained
unchanged despite the Yen’s strong appreciation.14
One important cause of the unchanging surplus was the pricing behaviour of
Japanese export enterprises, which reduced their export prices in reaction to the
Yen revaluation. The standard model of the elasticity approach is based on the
assumption of a small country that keeps the price constant and varies the supply
accordingly. The Japanese export enterprises however, reduced their prices in
Yen in order to stabilise their export market share. The export supply of Japanese
enterprises was more price elastic than expected.

a. Pass Through of Exchange Rate Fluctuations

The Japanese export enterprises tried to stabilise their market shares during
appreciation periods through price adjustments. Figure 5 shows the clear

14
See Krugman (1991) in reference to the adjustment of the Japanese current account to the Yen
appreciation after the Plaza Agreement.

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FIGURE 5
Exchange Rate and Export Prices (annual rates of change)

Source: IMF (various issues): International Financial Statistics.

correlation between exchange rate and export prices in Japan. The nominal
effective appreciation of the Yen (negative growth rate) was accompanied by
sinking export prices.
The correlation between Japan’s aggregated export price index on a Yen basis
and the nominal effective exchange rate within the observation period from
1980–1999 points to an imperfect shifting behaviour (pass through). In reaction
to an appreciation the expected loss of market share can be avoided through
lowered prices, even if the price elasticity of the demand on the target markets is
normal (Menon, 1995, pp. 197–98).
The long-term, cost unadjusted pass-through rate of the Japanese industry
within the observation period is 0.54.15 This means that only approximately half
of the appreciation passed through to foreign markets. While domestic prices
rose, export prices fell because of the appreciation. That the structural deviation
of the exchange rate from the general purchasing power parity is a direct
consequence, was proven in Section 2.

15
Own calculations. Khosla (1991) finds a value of 0.43 for the 1975–1987 period. Athukorala and
Menon (1994) using data from 1980–1992 find the total pass-through rate for Japanese
manufacturing exports to be 0.47.

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In effect the Japanese export enterprises were able to keep their products
competitive on international markets through price differentiation between
domestic and foreign markets. The example of the price development of industrial
goods in the USA and Japan gives proof to this assumption. The exports of Japan
consist largely of industrial goods. While the prices on the Japanese domestic
market (wholesale prices) fell about 10 per cent within the observation period, the
export prices in domestic currency sank by about 30 per cent. As a consequence,
the prices of Japanese industrial goods in the contract currency climbed clearly
slower than the prices of US industrial goods (Figure 6).16

b. International Price Setting and Productivity

The observed regional price differentiation of the Japanese enterprises raises
the issue of the instruments of price setting. Under the assumption of equal
production costs for goods sold domestically and those exported, the prices in

FIGURE 6
International Price Competition

Source: Bank of Japan (various issues): Economic Statistics Annual and United States, Council of Economic
Advisers (2000): Economic Report of the President.

16
In 1995, 35.7 per cent of the Japanese export contract were in Yen, 53.1 per cent in Dollars and
11.2 per cent in other currencies. Since the export price index in contractual currency also includes
goods factored in Yen, the export price index for the goods factored in Dollars tends to be higher
and approaches the American industrial goods price index.

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44 GUNTHER SCHNABL

different markets can only be differentiated through profit margins. An

appreciation of the domestic currency will shrink the profit margin as long as
it isn’t completely passed through.
Ohno (1990, pp. 296–98) explains the different pass-through behaviours of
Japanese and US enterprises observed in the 1980s with different time frames of
profit orientation. While the profit orientation is relatively short term for the
American enterprises, it is longer term for Japanese companies. Japanese
companies will put up with short term profit losses during exchange rate
fluctuations in order to stabilize their market share. A stable market share
promises higher earnings in the long run. American companies however, tend
towards a complete pass through in order to avoid profit loss in the short run.
Exchange rate movements do not change earnings if appreciation and
devaluation phases are similar in degree and length of time. According to
Loopesko and Johnson (1988, p. 126), Japanese export enterprises were able to
deal with the reduction in the profit margin after the appreciation following the
Plaza Agreement, because the profits in the preceding depreciation phase had
greatly increased. A company can also handle lower profit margins for a brief
period. However, if the appreciation continues into the long term, only cost
reductions can maintain the original returns. Profit margins and hedging are no
longer adequate buffers in this case.
Since the Yen had clearly appreciated over the observation period, the
exchange rate affected the Japanese export enterprises’ profits negatively. The
Japanese companies had to pass through the exchange rate fluctuations – and with
that probably had to take a loss in sales – or had to reduce their costs (Fukuhara,
1996, pp. 124–30; and Athukorala and Menon, 1994, pp. 272–73). Since the
appreciation was only partially passed through to foreign markets, the Japanese
export industry must have had to cut costs.
The break-even point, which is an indicator for such cost adjustments of the
Japanese industry, gives proof of this assumption.17 The break-even point of the
Japanese industry has sunk with the appreciation of the Yen since 1986,
indicating a significant reduction of production costs (Figure 7).
The total costs of a business can be broken down into imported input costs,
wage costs, and a cost component that originates from productivity increases. All
things being equal, if costs are reduced, the profit margin increases. The
particular cost components react differently to the exchange rate movements.
While the costs of imported inputs sink automatically with an appreciation (given
constant prices of the foreign supplier), a cautious wage policy and an increase in
productivity can help to further stabilise profits.

17
For the Japanese industry the break-even point is published annually by the Economic Planning
Agency on the basis of surveys within the Japanese export industry. The break-even point gives an
average Yen/Dollar rate for which the Japanese exports are still profitable.

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PURCHASING POWER PARITY: YEN/DOLLAR EXCHANGE RATE 45

FIGURE 7
Break-even Point of the Japanese Export Industry

Source: IMF (various issues): International Financial Statistics and Keizai Kikachô Chôsakyoku (various
issues): kigyô kôdô ni kan suru chôsa hôkokusho.

While the appreciation of the Yen made Japanese exports more expensive in
foreign countries, the import prices measured in Yen sank. As Kawai (1995, p.
57) argues, it is characteristic of the Japanese economy that in contrast to the
Japanese export prices in Yen, the prices of imported goods in foreign currency
remained relatively stable. While the Japanese businesses would have passed the
Yen appreciation through only partially, the foreign companies would pass it
through at almost 100 per cent to the Yen price of imported goods.18
The more imported inputs make up the total inputs, the more advantageous an
appreciation is for an enterprise. This advantage is due to the fact that an
appreciation reduces the imported input prices, given constant foreign supplier
prices. But since the net outputs comprised of exports for the total Japanese
industry (35.91 per cent) is much larger than that of the imports (23.55 per cent)
(1996), the disadvantages of the appreciation far outweighed the advantages. Cost
reduction was unavoidable.

18
The consequences of the appreciation are different on the export and import side. While the
market shares of the export enterprises shrink when passed through totally, the market shares of the
import enterprises are expected to grow.

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46 GUNTHER SCHNABL

The Japanese businesses have clearly limited wage increases in appreciation

phases (Figure 8). The Japanese wage and labour union system makes it possible
to adapt the wage costs to the core wage by cutting bonuses and overtime
(Okumara, 1995, p. 168). The increase in wages was clearly restricted especially
after the Plaza Agreement and in the early 1990s as the Yen reached new
heights. In this instance, the wage increases for the exchange rate dependent
branches, general machinery for example, were more apparent than for the
chemical industry, whose profit was stabilised through a high import share of the
inputs.
The part of the wage costs in the total costs of Japanese industry is too low to
compensate the exchange rate development on its own, however (Athukorala and
Menon, 1994, p. 273). According to Okumura (1995, p. 168) the Japanese
businesses avoid cutbacks if they can reduce their overall costs by lower input
costs or rationalisations in the production process. This means that Japanese
businesses have continually increased their productivity in their efforts to adjust
to the appreciation.
The productivity gains of Japanese enterprises were in fact much larger within
the observation period than those of American businesses (Marston, 1991). The
focus for the Japanese enterprises was on the rationalisation of the planning and

FIGURE 8
Wage Increases in Different Sectors of Japanese Industry

Source: Ministry of Labour (various issues): rôdô tôkei nenpô.

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PURCHASING POWER PARITY: YEN/DOLLAR EXCHANGE RATE 47

production processes. Fukuhara (1996, p. 124) takes the automobile industry as

an example; there the standardisation of parts, rationalisation of the planning
process, and co-operation with competitors were the foci of cost reductions
continuously accompanying the production process.19
According to the OECD Economic Outlook (1998, p. 312), the Japanese
economic productivity increased twice as fast between 1979 and 1998 as it did in
both the USA and Germany. While the German and American industries
increased their labour productivity by an average of 0.6 per cent annually, Japan
showed increases of around 1.2 per cent.20
The Japanese businesses were able to improve their competitiveness against
their foreign competition due to the high productivity gains and moderate wage
settlements. In this way, the unit labour costs increased more slowly than they did
in the USA and Germany. Since the productivity gains are normally reflected in
prices, the exchange rate of the Yen against the Dollar can also be approximated
by relative productivity.
Figure 9 shows the relative unit labour costs of Japan and the US compared
with the Yen-Dollar exchange rate. As in the case of general purchasing power
parity, the relative productivity shows the same trend, but with a structural
deviation of the exchange rate (see also Figure 1). This is because the unit labour
costs reflect the whole economy and include domestic sectors. It can therefore be
assumed that a sectoral productivity indicator of the respective export sector
would approximate the exchange rate more exactly – as observed in the
comparison of consumer and export prices.
The analysis of the Japanese industry’s productivity leads back to the
purchasing power parity theory as an explanation of the exchange rate, as it was
represented by Balassa and Samuelson. The long-term appreciation of the
Japanese currency goes back to relative productivity gains. The productivity
increase allowed price reductions on the international market, which in turn
brought the currency under appreciation pressure.
Besides the long term appreciation trend caused by productivity gains, it can
be observed that in the middle time period the price behaviour of Japanese export
enterprises influenced the exchange rate. In recession phases, export prices were
reduced in order to stabilise sales with increased exports, which caused – as
observed during the 1990s – the appreciation of the Yen. During the economic
upturns – as in the second half of the 1980s – the domestic sales recovered and
export prices were raised. This caused the depreciation of the Yen. Overall,
(export) prices are identified as the main determinant of the Yen’s exchange rate

19
The continuing rationalisation process which is practised especially in the auto industry is called
‘lean management’ in the western hemisphere.
20
Since the data refer to the whole economy and the productivity gap between domestic and export
sector is especially high in Japan, the productivity gains in the export sector must be even higher.

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48 GUNTHER SCHNABL

FIGURE 9
Yen/Dollar Exchange Rate and Relative Unit Labour Costs

Source: OECD (various issues): Economic Outlook and IMF (various issues) International Financial Statistics.

within the observation period of 1980 to 1999. The export prices influence the
exchange rate within a period of three months to one year. This time period is
much shorter as generally assumed.

5. CONCLUSION

Prices and productivity in the Japanese industry are central factors in

explaining the Yen exchange rate, as has been shown in this paper. In order to
keep their market share in the international markets, the Japanese enterprises have
continually reduced their export prices by way of moderate wage increases,
productivity increases and lower costs for imported inputs. The sinking prices in
the export market led to an appreciation of the Yen, according to the purchasing
power parity theory. The regression analysis based on relative export prices has
proven that for the case of the Japanese Yen the purchasing power parity not only
holds true in the very long run, but also shows significant results on the basis of
annual and even quarterly data.

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PURCHASING POWER PARITY: YEN/DOLLAR EXCHANGE RATE 49

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