that on some level PPP does not hold. The law of one price is fundamental to economic theory. Moreover, the Free Trade Agreement signed at the outset of the nineties means that the complete or perfect arbitrage is even more likely. It is therefore reasonable to assume that the differences in price levels push the exchange rate in a particular direction. In addition to the PPP factor, there is also the effect of interest rate differentials, which one would expect to be irrelevant over ten years unless there is a bubble factor which also would affect the exchange rate's direction. Finally, irrationality in the foreign exchange market could also serve to push the exchange rate one way or another. I would argue that the decline in the value of the Canadian dollar is a combination of these three factors.For the real exchange rate to have remained stable while the nominal rate depreciated 25% means that there must have been a change in the relative price level. However, as illustrated in the previous sections, the price levels have remained more or less constant. However, you will recall that in that case we used the CPI as a measure of price levels. What the CPI fails to incorporate however is the degree to which certain prices such as commodity prices are important to the overall economy. The point is that when comparing CPIs, we are unable to discern the fact Canada's economy relies relatively more on commodities than the US does, which is in fact the case. Thus, a drop in commodity prices might not affect the CPI but would effect the true price level. In fact in a recent paper by John Crow, affirms that commodity prices fell about 20% over the last ten years, which is about what the exchange rate fell by. Thus Canadian commodity producers were made "made whole." In addition to price level adjustment, structural change may also be also have an impact on the exchange rate. Djoudad and Tessier find that the dept to GDP ratio exp...
