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Between 1950 and 1971 the Japanese yen was fixed to the U.S. dollar at a nominal exchangerate that could vary by at most 1 percent from 360 per dollar. Since the early 1970s, whenthe dollar/yen exchange rate was allowed tofloator change in response to market forces, thecumulative appreciation of the yen against the dollar has been enormous. In the spring of 1999the dollar's price hovered near the 120 yen mark: In about 25 years, the dollar had lost twothirdsof its foreign exchange value against the yen!

This development cannot be explained by the simplest PPP theory because there has been nocorresponding rise in the U.S. commodity price level relative to Japan's. Can the extendedtheory of long-run nominal exchange rates we've developed throw light on the dollar's continuingdepreciation against the yen?A crucial first clue comes from looking at the behavior of the dollar's realexchange rateagainst the yen,

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implicationsfor real exchange rates than balanced output growth. In a careful study of industry-level data,University of Pennsylvania economist Richard C. Marston found that labor productivity growthin U.S. tradables exceeded that in U.S. nontradables by 13.2 percent over the 1973-1983period.In Japan, however, productivity growth in tradables outstripped that in nontradables by a

massive73.2 percent. These trends seem to have continued after 1983. A 1993 study commissioned bythe management consulting firm McKinsey & Co. found that by 1990, Japanese workers weresubstantially more productive than their U.S. counterparts in several key manufacturingindusCHAPTER15 Price Levels and the Exchange Rate in the Long Run 42 I

tries, including autos, auto parts, steel, and consumer electronics. In contrast, Japanese workersappeared less productive than American workers in nontraded goods.21Our earlier reasoning implies that the price of nontradables in terms of tradables shouldhave risen in both countries but that the increase should have been much greater in Japan. Thisreasoning fits the facts quite well: Marston found that over 1973-1983, the relative price of

nontradablesrose by 12.4 percent in the United States but by 56.9 percent in Japan. The prices ofJapanese-produced tradables did fall sharply relative to those of U.S. tradables, as the last section'stheory predicts, but not by nearly enough to offset the real exchange rate effect of Japan'sskyrocketing nontradables prices. Japan's more rapidly rising prices for nontraded goods, then,provide the basic reason why qVhas steadily increased.Figure 15-6 shows that the effect of unbalanced productivity growth on the price of nontradablesheld up for a cross-section of industrial countries over 1970-1985. The greater the gapbetween factor productivity growth in tradables and nontradables, the greater the rise in the relativeprice of nontraded goods, on average. As you can also see from the figure, Japan leads theindustrial countries in the rate of increase of its nontradables' prices, and, aside from Norway,

leads in the gap between traded and nontraded productivity gains.22 It is this pattern of productivitychange, coupled with Japanese inflation lower than America's, that has kept the yen risingagainst the dollar over most of the postwar period.