Chapter 16
Price Levels and the Exchange Rate
in the Long Run Add
1
Learning Objectives
16.1 Explain the purchasing power parity theory of exchange rates and the theory’s relationship to international goodsmarket integration.
16.2 Describe how monetary factors such as ongoing price level inflation affect exchange rates in the long run.
16.3 Discuss the concept of the real exchange rate.
Add
16.4 Understand factors that affect real exchange rates and relative currency prices in the long run.
16.5 Explain the relationship between international real interest rate differences and expected changes in real exchange rates.
Preview
• Law of one price
• Purchasing power parity
• Long-run model of exchange rates: monetary approach
• Relationship between interest rates and inflation: Fisher effect
Add
• Shortcomings of purchasing power parity
• Long-run model of exchange rates: real exchange rate approach
• Real interest rates
The Behavior of Exchange Rates (1 of 2)
• What models can predict how exchange rates behave? – In last chapter we developed a short-run model and a
long-run model that used movements in the money supply.
– In this chapter, we develop two more models, building on the long-run approach from last chapter. – Long run means a sufficient amount of time for prices of all goods and services to adjust to market conditions so that Add their markets and the money market are in equilibrium.
– Because prices are allowed to change, they will influence interest rates and exchange rates in the long-run models.
The Behavior of Exchange Rates (2 of 2)
Add
(1 of 3)
• The law of one price simply says that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important.
– Why? Suppose the price of pizza at one restaurant is $20, while the price of the same pizza at an identical restaurant across the street is $40.Add – What do you predict will happen? Many people will buy the $20 pizza, few will buy the $40 one. (2 of 3)
– People would have an incentive to adjust their behavior and prices would tend to adjust until one price is achieved across markets (across restaurants).
(3 of 3)
• Consider a pizza restaurant in Seattle and one across the border in Vancouver.
• The law of one price says that the price of the same pizza (using a common currency to measure the price) in the two cities must be the same if markets are competitive and transportation costs and barriers between markets are not important.
𝑃 =Add 𝐸 $/ $ ×𝑃
P pizzaUS = priceof pizzainSeattle
P pizzaCanada = priceof pizzainVancouver
EUS$/C$ = U.S.dollar / Canadiandollar exchangerate
(1 of 3)
• Purchasing power parity is the application of the law of one price across countries for all goods and services, or for representative groups (“baskets”) of goods and services.
$/ $
Add PUS = level of average prices in the U.S.
PCanada = level of average prices in Canada
EUS$/C$ = U.S.doller / Canadian doller exchange rate
(2 of 3)
• Purchasing power parity (PPP) implies that the exchange rate is determined by levels of average prices
EUS$ PUS C$ PCanada Add
– If the price level in the United States is US$200 per basket, while the price level in Canada is C$400 per basket, PPP implies that the C$/US$ exchange rate should be C$400 /US$200 C$2 /US$1.
– Predicts that people in all countries have the same purchasing power with their currencies: 2 Canadian dollars buy the same amount of goods as 1 U.S. dollar, since prices in Canada are twice as high. (3 of 3)
• Purchasing power parity (PPP) comes in two forms:
• Absolute PPP: purchasing power parity that has already been discussed.
Exchange rates equal the level of relative average prices across countries.
$/€=
• Relative PPP: changes in exchange rates equal changes in prices
(inflation) between two periods: Add
$ $
, , € €
= , ,
$
,
€
where t inflation rate from perid t 1 to t
(1 of 5)
• Monetary approach to the exchange rate: uses monetary factors to predict how exchange rates adjust in the long run, based on the absolute version of PPP.
– It predicts that levels of average prices across countries adjust so that the quantity of real monetary assets supplied will equal the quantity of real monetary assets demanded:
Add
MSUS PUS L R Y $ US,
MSEU
PEU
L R Y €, EU
(2 of 5)
• To the degree that PPP holds and to the degree that prices adjust to equate the quantity of real monetary assets supplied with the quantity of real monetary assets demanded, we have the following prediction:
– The exchange rate is determined in the long run by prices, which are determined by the relative supply and demand of real monetary assets in money Add markets across countries.
(3 of 5)
Predictions about changes in 1. Money supply: a permanent rise in the domestic money supply
– causes a proportional increase in the domestic price level,
– thus causing a proportional depreciation in the domestic currency
(through PPP).
– This is same prediction as long-run model without PPP.
Add
2. Interest rates: a rise in domestic interest rates
– lowers the demand of real monetary assets,
– and is associated with a rise in domestic prices, – thus causing a proportional depreciation of the domestic currency (through PPP).
(4 of 5)
3. Output level: a rise in the domestic level of production and income (output)
– raises domestic demand of real monetary assets, – and is associated with a decreasing level of average
domestic prices (for a fixed quantity of money supplied),
– thus causing a proportional appreciation of the domestic currency (through PPP).Add
• All three changes affect money supply or money demand, and cause prices to adjust so that the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, and cause exchange rates to adjust according to PPP.
(5 of 5)
• A change in the money supply results in a change in the level of average prices.
• A change in the growth rateof the money supply results in a change in the growth rate of prices (inflation). – A constant growth rate in the money supply results in a persistent growth rate in prices (persistent inflation) at the same constant rate, when other factors are constant.Add
– Inflation does not affect the productive capacity of the economy and real income from production in the long run. – Inflation, however, does affect nominal interest rates.
How?
The Fisher Effect (1 of 2)
• The Fisher effect (named affect Irving Fisher) describes the relationship between nominal interest rates and inflation. – Derive the Fisher effect from the interest parity condition:
$ €=https://$/€ $/€.com
$/€
Add – If financial markets expect (relative) PPP to hold, then expected exchange rate changes will equal expected inflation between countries:
€ = $/€ $/€ –
$/€
The Fisher Effect (2 of 2)
– Therefore, R R$ € eUS eEU
– The Fisher effect: a rise in the domestic inflation rate causes an equal rise in the interest rate on deposits of domestic currency in the long run, when other factors remain constant.
Add
Monetary Approach to Exchange Rates (1 of 2)
• Suppose that the U.S. central bank unexpectedly increases the growth rate of the money supply at time t0.
• Suppose also that the inflation rate is in the United States before t0and after this time, but that the European inflation rate remains at 0%.
Add • According to the Fisher effect, the interest rate in the United States will adjust to the higher inflation rate. Figure 16.1 Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money Supply
Monetary Approach to Exchange Rates (2 of 2)
• The increase in nominal interest rates decreases the demand of real monetary assets.
• In order for the money market to maintain equilibrium in the long run, prices must jump
so that
MS
PUS US L R Y $, US
• In order to maintain PPP, the exchange rate must jump (the dollar must depreciate) so that Add
$/€=
• Thereafter, the money supply and prices are predicted to grow at rate and the domestic currency is predicted to depreciate at the same rate.
(1 of 5)
• There is little empirical support for absolute purchasing power parity.
– The prices of identical commodity baskets, when converted to a single currency, differ substantially across countries.
• Relative PPP is more consistent with data, but it also
Add performs poorly to predict exchange rates.
Relative PPP does not track the yen/dollar exchange rate 1980-2015.
Source: IMF, International Financial Statistics. Exchange rates and price levels are end of the year data,. (2 of 5)
1. Trade barriers and nontradable products
Shortcomings of PPP
2. Imperfect competition
3. Differences in measures of average prices for baskets of goods and services Add
Shortcomings of PPP
(3 of 5)
• Trade barriers and nontradable products – Transport costs and governmental trade restrictions make trade expensive and in some cases create nontradable goods or services.
– Services are often not tradable: services are
generally offered within a limited geographic region
(e.g., haircuts). Add
– The greater the transport costs, the greater the range over which the exchange rate can deviate from its PPP value. – One price need not hold in two markets.
(4 of 5)
“pricing to market.”
Shortcomings of PPP
– A firm sells the same product for different prices in different markets to maximize profits, based on expectations about what consumers are willing to pay. – One price need not hold in two markets.Add
(5 of 5)
• Differences in the measure of average prices for goods and services – Levels of average prices differ across countries because of differences in how representative groups (“baskets”) of goods and services are measured. – Because measures of groups of goods and services are different, the measure of their average prices Add need not be the same.
– One price need not hold in two markets.
Law of One Price for Hamburgers?
(1 of 3)
• When expressed in terms of a single currency, countries’ price levels are positively related to the level of real income per capita.
– A dollar, when converted to local currency at the market exchange rate, generally goes much further in a poor country than in a rich one.
– Figure 16-3 illustrates the relation between price levels Add and income, with each dot representing a different country.
• Non-tradables tend to be more expensive (relative to tradables) in richer countries. (2 of 3)
• The Balassa-Samuelson theory assumes labor productivity in poor countries is substantially lower than in rich countries for tradables but not for non-tradables.
Why Price Levels Are Lower in Poorer Countries
• If the prices of traded goods are roughly equal across countries, the lower labor productivity in the tradables industries of poor countries implies lower wages, lower production costs in non-tradables, and thus lower prices of Add non-tradables than rich countries.
• Productivity statistics support the Balassa-Samuelson differential productivity explanation. (3 of 3)
• An alternative theory (by Bhagwati, Kravis, and Lipsey) relies on differences in the endowments of capital and labor, rather than productivity differences.
• The higher capital-labor ratios in rich countries compared to poor countries makes the marginal productivity of labor and hence the wage level higher in rich countries. Add
• Non-tradables are labor-intensive (use a higher ratio of labor to capital) relative to tradables, making non-tradables cheaper in poor, low-wage countries than they are in rich, high-wage countries.
• Rich countries thus have higher overall price levels.
Figure 16.3 Price Levels and Real
Consumer price levels tend to rise as their real income rises. Each dot represents a country. The straight line represents a statistician’s best prediction of a country’s price level relative to that of the United States based on its real per capita income.
Source: Penn World Table, version 9.1.
(1 of 10)
• Because of the shortcomings of PPP, economists have tried to generalize the monetary approach to PPP to make a better theory.
• The real exchange rateis the rate of exchange for goods and services across countries.
– In other words, it is the relative value/price/cost of goods and services across countries.
– For example, it is the dollar price of a European group of goods Add and services relative to the dollar price of an American group of goods and services:
E$/ € PEU qUS
EU PUS
(2 of 10)
E$/ € PEU qUS
EU PUS
– If the EU basket costs € 100, the U.S. basket costs $120, and the
nominal exchange rate is $1.20 per euro, then the real exchange rate is 1 U.S. basket per 1 EU basket.
– A real depreciation of the value of U.S. products means a fall in a Add dollar′s purchasing power of EU products relative to a dollar′s purchasing power of U.S. products.
▪ This implies that U.S. goods become less expensive and less valuable relative to EU goods.
▪ This implies that the value of U.S. goods relative to value of EU goods falls.
(3 of 10)
E$/ € PEU qUS
EU PUS
– A real appreciation of the value of U.S. products
means a rise in a dollar’s purchasing power of EU products relative to a dollar’s purchasing power of Add U.S. products.
▪ This implies that U.S. goods become more expensive and more valuable relative to EU goods.
▪ This implies that the value of U.S. goods relative to value of EU goods rises. (4 of 10)
• According to PPP, exchange rates are determined by relative average prices:
PUS E$/ € PEU
PUS
E$/ € qUS EU PEU • What influences the real exchange rate?
(5 of 10)
• A change in relative demand of U.S. products
– An increase in relative demand of U.S. products causes the value
(price) of U.S. goods relative to the value (price) of foreign goods to rise.
– A real appreciation of the value of U.S. goods: PUS rises relative to
E P$/ € EU
Add
– The real appreciation of the value of U.S. goods makes U.S. exports more expensive and imports into the U.S. less expensive (thereby reducing the relative quantity demanded of U.S. products).
– A decrease in relative demand of U.S. products causes a real depreciation of the value of U.S. goods. (6 of 10)
• A change in relative supply of U.S. products
– An increase in relative supply of U.S. products (caused by an increase in U.S. productivity) causes the price/cost of U.S. goods relative to the price/cost of foreign goods to fall.
– A real depreciation of the value of U.S. goods:PUS falls relative to
E P$/ € EU
Add
– The real depreciation of the value of U.S. goods makes U.S. exports less expensive and imports into the United States more expensive (thereby increasing relative quantity demanded to match increased relative quantity supplied).
– A decrease in relative supply of U.S. products causes a real appreciation of the value of U.S. goods.
Figure 16.4 Determination of the Long-
Run Real Exchange Rate
The long-run equilibrium real exchange rate equates world relative demand to the full-employment level of relative supply.
(7 of 10)
• The real exchange rate is a more general approach to explain exchange rates. Both monetary factors and real factors influence nominal exchange rates:
1a. Increases in monetary levels lead to temporary inflation and changes in expectations about inflation.
1b. Increases in monetary growth rates lead to persistent inflation and changes in expectations about inflation.Add
2a. Increases in relative demand of domestic products lead to a real appreciation.
2b. Increases in relative supply of domestic products lead to a real depreciation. (8 of 10)
• What are the effects on the nominal exchange rate?
The Real Exchange Rate Approach to Exchange Rates
P
AssignE$/ € qmUS ent Project Exam HelpUS EU PEU
• When only monetary factors change and PPP holds, we have the same predictions as before. – No changes in the real exchange rate occurs.
Add
• When factors influencing real output change, the real exchange rate changes. – With an increase in relative demand of domestic products, the real exchange rate adjusts to determine nominal exchange rates.
– With an increase in relative supply of domestic products, the situation is more complex. (9 of 10)
• With an increase in the relative supply of domestic products, the real exchange rate adjusts to make the price/cost of domestic goods depreciate, but the relative amount of domestic output also increases.
– This second effect increases the demand of real monetary assets in the domestic economy: MSUS
PUS
L R Y $, US
Add
The Real Exchange Rate Approach to Exchange Rates
– Thus the level of average domestic prices is predicted to decrease relative to the level of average foreign prices.
– The effect on the nominal exchange rate is ambiguous:
P E$/
€ qUS US
EU PEU
?
(10 of 10)
• When economic changes are influenced only by monetary factors, and when the assumptions of PPP hold, nominal exchange rates are determined by PPP. • When economic changes are caused by factors that affect real output, exchange rates are not determined by
PPP only, but are also influenced by the real exchange
rate. Add
Interest Rate Differences
• A more general equation of differences in nominal interest rates across countries can be derived from
qeUS/EU qUS/EUAss ignmenEe$/ € E$/ € t Project Exam Helpe e US EU qUS/EU E$/ €
Ee$/ € E$/ €
R R$ €
E$/ €
qeUS/EUAdd qUS/EU e e
R R$ € US EU
qUS/EU
• The difference in nominal interest rates across two countries is now the sum of
– the expected rate of depreciation in the value of domestic goods relative to foreign goods, and
– the difference in expected inflation rates between the domestic economy and the foreign economy.
Table 16.1 Effects of Money Market and Output Market
Changes on the Long-Run Nominal Dollar/Euro Exchange Rate, EE sub dollar per euro$/€ (1 of 2)
Money market
Change Effect on the Long-Run Nominal Dollar/Euro ent Project Exam
Rate, E sub dollar per euro E$/€
1. Increase in U.S. money supply level Proportional increase (nominal depreciation of $)
decrease (nominal depreciation of euro)
3. Increase in U.S. money supply growth rate Increase (nominal depreciation of $)
powcoderDecrease (nominal
depreciation of euro)
Table 16.1 Effects of Money Market and Output Market
Changes on the Long-Run Nominal Dollar/Euro Exchange Rate, EE sub dollar per euro$/€ (2 of 2)
Table 16.1 [Continued]
Output market
Change Effect on the Long-Run Nominal Dollar/Euro
E
Exchange Rate, E sub dollar per euro $/€
( nominal appreciation of $)
2. Increase in demand for European output Increase (nominal appreciation of euro)
powcoderAmbiguous
4. Output supply increase in Europe Ambiguous
Real Interest Rates (1 of 2)
• Real interest rates are inflation-adjusted interest rates:
re R e e
where represents the expected inflation rate and R represents a measure of nominal interest rates.
• Real interest rates are measured in terms of real output:
– the quantity of goods and services that savers can purchase Add when their assets pay interest – the quantity of goods and services that borrowers cannot purchase when they must pay interest on their loans
• What are the predicted differences in real interest rates across countries?
Real Interest Rates (2 of 2)
• Real interest rate differentials are derived from
reUS reEU R$ eUS R€ eEU
e
R R$ €
qUS/EU
e e qeAdd WeUS/EU qUS/EU Chat
r US r EU
qUS/EU
• The last equation is called real interest parity.
– It says that differences in real interest rates (in terms of goods and services that are earned or forgone when lending or borrowing) between countries are equal to the expected change in the value/price/cost of goods and services between countries.
(1 of 4)
1. The law of one price says that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between markets are not important. 2. Purchasing power parity applies the law of one price for all goods and services among all countries.
Add – Absolute PPP says that currencies of two countries have the same purchasing power.
– Relative PPP says that changes in the nominal exchange rate between two countries equals the difference in the inflation rates between the two countries. (2 of 4)
3. The monetary approach to exchange rates uses PPP and the supply and demand of real monetary assets.
– Changes in the growth rate of the money supply influence inflation and exchange rates.
– Expectations about inflation influence the exchange rate. – The Fisher effect shows that differences in nominal interest rates are equal to differences in inflation rates.Add
4. Empirical support for PPP is weak.
5. The real exchange rate approach to exchange rates generalizes the monetary approach.
– It defines the real exchange rate as the value/price/cost of domestic products relative to foreign products.
– It predicts that changes in relative demand and relative
supply of products influence real and nominal exchange rates. Add
– Interest rate differences are explained by a more general concept: expected changes in the value of domestic products relative to the value of foreign products plus the difference of inflation rates between the domestic and foreign economies.
(4 of 4)
6. Real interest rates are inflation-adjusted interest rates, and show how much purchasing power savers gain and borrowers give up.
7. Real interest parity shows that differences in real interest rates between countries equal expected changes in the real value of goods and services
between countries. Add
Figure 16A.1 How a Rise in U.S. Monetary Growth Affects
Dollar Interest Rates and the Dollar/Euro Exchange Rate When Goods Prices Are Flexible
