Working Paper: NBER ID: w2761
Authors: Paul Krugman
Abstract: One might expect that differences in income elasticities in trade and/or differences in growth rates among countries would give rise to strong secular trends in real exchange rates; for example, fast-growing countries might need steady depreciation to get the world to accept their growing exports. In fact, however, income elasticities are systematically related to growth rates by the "45-degree rule", under which fast-growing countries appear to face high income elasticities of demand for their exports, while having low income elasticities of import demand. The net effect of this relationship between elasticities and growth rates is that secular trends in real exchange rates 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 suggests an explanation in terms of increasing returns and product differentiation.
Keywords: income elasticities; real exchange rates; purchasing power parity
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fast-growing countries (O57) | High income elasticities of demand for exports (F14) |
| Fast-growing countries (O57) | Low income elasticities of demand for imports (D12) |
| High income elasticities of demand for exports (F14) | Smaller expected trends in real exchange rates (F31) |
| Low income elasticities of demand for imports (D12) | Smaller expected trends in real exchange rates (F31) |
| Systematic relationship between growth rates and income elasticities (O40) | Absence of significant shifts in real exchange rates (F31) |
| Income elasticities of demand are correlated with growth rates (F62) | Relative purchasing power parity holds better than expected (F31) |