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 ß Blackwell Publishers Ltd 2001, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA. 31 GUNTHER SCHNABL is from Tu ¨bingen University. He is grateful to Dirk Baur and two anonymous referees for their very helpful comments.