1 ch. 15: price levels and the exchange rate in the long run

11

Ch. 15: Price Levels and the Exchange Rate in the Long Run

22

The Behavior of Exchange RatesThe Behavior of Exchange Rates What models can predict how exchange rates behave?What models can predict how exchange rates behave?

In last chapter we developed a short run model and a long run In last chapter we developed a short run model and a long run model that used movements in the money supply.model that used movements in the money supply.

In this chapter, we develop 2 more models, building on the long In this chapter, we develop 2 more models, building on the long run approach from last chapter.run approach from last chapter.

Long run means that prices of goods and services and factors of Long run means that prices of goods and services and factors of production that build those goods and services adjust to supply production that build those goods and services adjust to supply and demand conditions so that their markets and the money and demand conditions so that their markets and the money market are in equilibrium.market are in equilibrium.

Because prices are allowed to change, they will influence Because prices are allowed to change, they will influence interest rates and exchange rates in the long run models.interest rates and exchange rates in the long run models.

33

The Behavior of Exchange RatesThe Behavior of Exchange Rates

The long run models are not intended to be The long run models are not intended to be completely realistic descriptions about how completely realistic descriptions about how exchange rates behave, but ways of exchange rates behave, but ways of generalizing how market participants form generalizing how market participants form expectations about future exchange rates.expectations about future exchange rates.

44

Law of One PriceLaw of One Price

The The law of one pricelaw of one price simply says that the simply says that the samesame good in different competitive markets must sell good in different competitive markets must sell for the same price, when transportation costs for the same price, when transportation costs and barriers between markets are not important.and barriers between markets are not important. Why? Suppose the price of pizza at one restaurant is Why? Suppose the price of pizza at one restaurant is

$20, while the price of the same pizza at a similar $20, while the price of the same pizza at a similar restaurant across the street is $40.restaurant across the street is $40.

What do you predict to happen? What do you predict to happen? Many people would buy the $20 pizza, few would buy Many people would buy the $20 pizza, few would buy

the $40. the $40.

55

Law of One PriceLaw of One Price Consider a pizza restaurant in Seattle one across the Consider a pizza restaurant in Seattle one across the

border in Vancouver. border in Vancouver. The law of one price says that the price of the same The law of one price says that the price of the same

pizza (using a common currency to measure the price) pizza (using a common currency to measure the price) in the two cities must be the same if barriers between in the two cities must be the same if barriers between competitive markets and transportation costs are not competitive markets and transportation costs are not important:important:

PPpizzapizzaUSUS = (= (EEUS$/Canada$US$/Canada$) x ) x ((PPpizzapizza

CanadaCanada))

PPpizzapizzaUS US = price of pizza in Seattle= price of pizza in Seattle

PPpizzapizzaCanadaCanada = price of pizza in Vancouver = price of pizza in Vancouver

EEUS$/Canada$US$/Canada$ = US dollar/Canadian dollar exchange rate = US dollar/Canadian dollar exchange rate

66

Law of One PriceLaw of One PriceAssumptionsAssumptions

Competitive marketsCompetitive marketsNo trade barriersNo trade barriersNo transportation costsNo transportation costs

Identical products must sell at the same Identical products must sell at the same price.price.

A Sony TV selling for $100 in the US and A Sony TV selling for $100 in the US and ¥12,000 in Japan implies an exchange rate ¥12,000 in Japan implies an exchange rate of ¥120 per dollar.of ¥120 per dollar.

77


If the Sony TV sold for $100 or ¥12,000 If the Sony TV sold for $100 or ¥12,000 but the exchange rate were ¥100 per but the exchange rate were ¥100 per dollar, what would happen in a dollar, what would happen in a frictionless trade environment?frictionless trade environment?

• People would buy TVs in US, and sell them in Japan. For a Japanese entrepreneur, ¥10,000 would get him $100, buy the TV, and sell it for ¥12,000. A sure 20% return.

ARBITRAGE

88

Law of One PriceLaw of One Price If people from Japan embarked on this If people from Japan embarked on this

endeavor, there would be more demand endeavor, there would be more demand for $ and more supply of ¥ in the forex for $ and more supply of ¥ in the forex market.market.

USD would appreciate and ¥ would USD would appreciate and ¥ would depreciate.depreciate.

The forex market would feel the The forex market would feel the pressure of $ appreciation until ¥120 pressure of $ appreciation until ¥120 per dollar rate is reached.per dollar rate is reached.

99


If prices in both localities are equal, then If prices in both localities are equal, then

PP$$ = ($/¥) P = ($/¥) P¥¥ or P or P¥¥ = (¥/$) P = (¥/$) P$$..

By the same token, PBy the same token, P¥¥/P/P$$ = (¥/$) or = (¥/$) or

PP$$/P/P¥¥ = ($/¥). = ($/¥).

1010

Purchasing Power ParityPurchasing Power ParityGeneralizing from the law of one price, Generalizing from the law of one price,

the price levels representing similar the price levels representing similar basket of goods and products should be basket of goods and products should be equal to the exchange rate.equal to the exchange rate.

PPUSUS/P/PJapanJapan = ($/¥) = ($/¥)

Alternatively, PAlternatively, PUSUS = ($/¥) P = ($/¥) PJapan Japan or price or price

level in US is the same as price level in level in US is the same as price level in Japan when measured in terms of $.Japan when measured in terms of $.

1111

Purchasing Power ParityPurchasing Power Parity If law of one price holds and both countries If law of one price holds and both countries

have exactly same baskets, PPP will hold, have exactly same baskets, PPP will hold, too.too.

PPP should indicate general tendency even PPP should indicate general tendency even if law of one price fails in some cases:if law of one price fails in some cases:The higher priced goods will lose demand and The higher priced goods will lose demand and

the currency will depreciate.the currency will depreciate.The increased demand for lower priced goods The increased demand for lower priced goods

will force the currency to appreciate.will force the currency to appreciate.

1212

Purchasing Power ParityPurchasing Power ParitySay, PSay, PUSUS / P / PJapanJapan > ($/¥). > ($/¥).Demand for Japanese products, hence Demand for Japanese products, hence

yen, will rise.yen, will rise.Demand for American products, hence Demand for American products, hence

USD, will fall.USD, will fall.Yen will appreciate and $ will Yen will appreciate and $ will

depreciate.depreciate. PPUSUS / P / PJapanJapan = ($/¥). = ($/¥).

1313

Relative PPPRelative PPPPPUSUS / P / PJapanJapan = ($/¥) implies that if inflation = ($/¥) implies that if inflation

in US were greater than in Japan, then in US were greater than in Japan, then ¥ should appreciate and $ depreciate.¥ should appreciate and $ depreciate.

PPUS0US0 / P / PJapan0Japan0 = ($/¥) = ($/¥)00

PPUS1US1 > P > PJapan1Japan1 ($/¥) ($/¥)00

PPUS1US1 = P = PJapan1Japan1 ($/¥) ($/¥)11

1414

Purchasing Power ParityPurchasing Power Parity

Purchasing power parity comes in 2 forms:Purchasing power parity comes in 2 forms:

Absolute PPPAbsolute PPP: Exchange rates equal price : Exchange rates equal price levelslevels across countries.across countries.

EE$/€$/€ = = PPUSUS//PPEUEU

Relative PPPRelative PPP: : changeschanges in exchange rates equal in exchange rates equal changeschanges in prices (inflation) between two periods: in prices (inflation) between two periods:

((EE$/€,$/€,t t - E- E$/€, $/€, tt –1 –1)/)/EE$/€, $/€, tt –1 –1 = = US, US, t t - - EU, EU, t t

where where t t = inflation rate from period = inflation rate from period t-1t-1 to to tt

1515

Monetary Approach to Monetary Approach to Exchange Rate DeterminationExchange Rate Determination

1.1. This is a long run, flexible price condition.This is a long run, flexible price condition.

2.2. Assume PPP holds.Assume PPP holds.

3.3. Assume price level in a country is Assume price level in a country is determined by the supply and real demand determined by the supply and real demand for money.for money.

4.4. The result is exchange rate, which is equal The result is exchange rate, which is equal to relative price levels in two countries to relative price levels in two countries under PPP, is determined by relative money under PPP, is determined by relative money supplies and demands.supplies and demands.

1616

Monetary Approach to Exchange Monetary Approach to Exchange Rate DeterminationRate Determination

($/€) = PUS/PEurope (PPP condition)Md = P L(R,Y) (Money demand)Md/P = L(R,Y) (Real money demand)Md = Ms or Md/P = Ms/P (Equilibrium)Ms/P = L(R,Y) (Equilibrium)P = Ms/L(R,Y) (Equilibrium)($/€) = [Ms/L(R,Y)]US/[Ms/L(R,Y)]Europe

1717

Monetary Approach Monetary Approach to Exchange Ratesto Exchange Rates

To the degree that PPP holds and to the degree To the degree that PPP holds and to the degree that prices adjust to equate real money supply that prices adjust to equate real money supply with real money demand, we have the following with real money demand, we have the following prediction: prediction:

The exchange rate is determined in the long run The exchange rate is determined in the long run by prices, which are determined by the relative by prices, which are determined by the relative supply of money across countries and the supply of money across countries and the relative real demand of money across countries. relative real demand of money across countries.

1818


A permanent increase in the US money A permanent increase in the US money supply will cause a proportional increase supply will cause a proportional increase in the US price level and force $ to in the US price level and force $ to depreciate and € to appreciate.depreciate and € to appreciate.

For instance, a 15% increase in US money For instance, a 15% increase in US money supply will raise the price level by 15% supply will raise the price level by 15% and appreciate the euro by 15%.and appreciate the euro by 15%.

1919

Monetary Approach to Exchange Monetary Approach to Exchange Rate DeterminationRate Determination

If Europe grew faster than US, European Y If Europe grew faster than US, European Y will be relatively higher.will be relatively higher.

Real demand for money in Europe will rise.Real demand for money in Europe will rise.Given the same money supply, and interest Given the same money supply, and interest

rates not fully accommodate demand, price rates not fully accommodate demand, price level in Europe will fall.level in Europe will fall.

Euro will appreciate and USD will Euro will appreciate and USD will depreciate.depreciate.

2020


A drop in the interest rates in the US A drop in the interest rates in the US increases the real demand for money.increases the real demand for money.

To fulfill the equilibrium condition, as long To fulfill the equilibrium condition, as long as money supply hasn’t changed, price as money supply hasn’t changed, price level has to fall.level has to fall.

If there was no change in Europe, the euro If there was no change in Europe, the euro will depreciate and the USD will will depreciate and the USD will appreciate.appreciate.

2121


This analysis yields two results:This analysis yields two results:1.1. Long run exchange rate depreciates with Long run exchange rate depreciates with

increasing money supply.increasing money supply.2.2. Increases in interest rates depreciate the Increases in interest rates depreciate the

currency by lowering the real demand for currency by lowering the real demand for money.money.

The second conclusion contradicts what The second conclusion contradicts what interest parity condition predicts.interest parity condition predicts.

2222

The ContradictionThe Contradiction The way a change in interest rate affects the The way a change in interest rate affects the

exchange rate depends on the reason why exchange rate depends on the reason why interest rates have changed in the first place.interest rates have changed in the first place.

If the interest rate has risen because of If the interest rate has risen because of inflation, the expected depreciation of the inflation, the expected depreciation of the currency will force the spot rate to depreciate currency will force the spot rate to depreciate as well.as well.

If the interest rate rose because of lower If the interest rate rose because of lower savings or higher investments, then interest savings or higher investments, then interest parity will force the spot rate to appreciate.parity will force the spot rate to appreciate.

More ContradictionMore Contradiction

Suppose people in US decide to save Suppose people in US decide to save more.more.

What happens to real interest rate?What happens to real interest rate?What happens to inflation?What happens to inflation?What happens to nominal interest rate?What happens to nominal interest rate?What happens to P in US?What happens to P in US?What happens to $?What happens to $?

2323

2525

Inflation and Interest ParityInflation and Interest Parity%Δ(P%Δ(PUSUS/P/PEuropeEurope)= %Δ ($/€))= %Δ ($/€) If this becomes part of the expectation, If this becomes part of the expectation,

then the interest parity condition can be then the interest parity condition can be rewritten as Rrewritten as R$$ = R = R€€ + %Δ ($/€). + %Δ ($/€).

Alternatively, RAlternatively, R$$ - R - R€€ = US inflation – Euro = US inflation – Euro

inflation.inflation.The difference between interest rates has The difference between interest rates has

to reflect the expected inflation in both to reflect the expected inflation in both countries.countries.

2626

The Fisher EffectThe Fisher Effect Nominal interest rate is equal to real Nominal interest rate is equal to real

interest rate plus the expected inflation interest rate plus the expected inflation rate.rate.

In the long run, real interest rate, like In the long run, real interest rate, like other real variables, has no bearing to other real variables, has no bearing to the monetary sector.the monetary sector.

An increase in the money growth that An increase in the money growth that increases the inflation rate will raise the increases the inflation rate will raise the nominal interest rate by the additional nominal interest rate by the additional inflation rate.inflation rate.

2727

NotationNotation

Suppose in the long run the growth rate of Suppose in the long run the growth rate of money supply, (Mmoney supply, (M11-M-M00)/M)/M00, is given by π., is given by π.

Inflation will also equal to π. Inflation will also equal to π. From the previous discussion, the From the previous discussion, the

depreciation of the currency should also depreciation of the currency should also equal π.equal π.

If the long run path of the money growth If the long run path of the money growth increases to π+Δπ, then inflation and increases to π+Δπ, then inflation and depreciation will also increase to π+Δπ.depreciation will also increase to π+Δπ.

2828

Time PathsTime Paths

time time

timetime

t1t1

t1 t1

Moneysupply

Slope=π

Slope=πSlope=π

Pricelevel

$/€

Interestrate

Slope=π+

Slope=π+ Slope=π+

R

R+

2929

Future Rate of M Growth Up, Future Rate of M Growth Up, P FlexibleP Flexible

R

$/€ $/€

M/P

M/P

R

R

R

PPP

Future M growth up. P rises. M/P drops.

Expected inflationmakes expected value of the $depreciate.

Current value of USD falls even though R has increased: Fishereffect.

3030

Source of R IncreaseSource of R Increase In the sticky price case, R increases In the sticky price case, R increases

due to M decrease.due to M decrease.Lower M/P matches the real demand at Lower M/P matches the real demand at

higher R.higher R. Inflationary expectations are lower.Inflationary expectations are lower.Expected exchange value of USD rises Expected exchange value of USD rises

because of lower expected inflation: because of lower expected inflation: relative PPP.relative PPP.

Current exchange value of USD rises Current exchange value of USD rises because of interest parity.because of interest parity.

3131

Graphical ExplanationGraphical Explanation

Money supply decrease raised R and appreciated $.

$/¥

R$

3232

Source of R IncreaseSource of R Increase In the flexible price case, R increases due to In the flexible price case, R increases due to

rise in inflationary expectations.rise in inflationary expectations.An increase in the future growth rate of money An increase in the future growth rate of money

supply means prices in the future will rise at the supply means prices in the future will rise at the same growth rate as the money growth.same growth rate as the money growth.

Perfect flexibility makes current price level rise.Perfect flexibility makes current price level rise.Real supply of money drops.Real supply of money drops.Expected inflation depreciates the expected Expected inflation depreciates the expected

value of USD in the forex market: relative PPP.value of USD in the forex market: relative PPP. Interest parity makes current forex value of USD Interest parity makes current forex value of USD

drop.drop.

3333

Empirical Evidence on PPPEmpirical Evidence on PPPTests to confirm absolute PPP have Tests to confirm absolute PPP have

largely failed.largely failed.Tests to confirm relative PPP have Tests to confirm relative PPP have

mixed results.mixed results.Tests to confirm law of one price did not Tests to confirm law of one price did not

fare well, either.fare well, either.The Economist’sThe Economist’s Big Mac PPP shows Big Mac PPP shows

wide divergences.wide divergences.

3434http://www.economist.com/finance/displaystory.cfm?story_id=E1_GJSNQSS

WHEN our economics editor invented the Big Mac index in 1986 as a light-hearted introduction to exchange-rate theory, little did she think that 20 years later she would still be munching her way, a little less sylph-like, around the world. As burgernomics enters its third decade, the Big Mac index is widely used and abused around the globe. It is time to take stock of what burgers do and do not tell you about exchange rates.The Economist's Big Mac index is based on one of the oldest concepts in international economics: the theory of purchasing-power parity (PPP), which argues that in the long run, exchange rates should move towards levels that would equalise the prices of an identical basket of goods and services in any two countries. Our “basket” is a McDonald's Big Mac, produced in around 120 countries. The Big Mac PPP is the exchange rate that would leave burgers costing the same in America as elsewhere. Thus a Big Mac in China costs 10.5 yuan, against an average price in four American cities of $3.10 (see the first column of the table). To make the two prices equal would require an exchange rate of 3.39 yuan to the dollar, compared with a market rate of 8.03. In other words, the yuan is 58% “undervalued” against the dollar. To put it another way, converted into dollars at market rates the Chinese burger is the

cheapest in the table.

2006

3636

Failure of PPPFailure of PPP

1.1. Failure of the law of one price.Failure of the law of one price.

2.2. Transport costs and government Transport costs and government regulations to restrict trade.regulations to restrict trade.

3.3. Monopolistic and oligopolistic Monopolistic and oligopolistic practices. Product differentiation.practices. Product differentiation.

4.4. Differences in commodity baskets of Differences in commodity baskets of different countries.different countries.

5.5. Cost of nontradable inputs.Cost of nontradable inputs.

3737

Law of One PriceLaw of One Price If the law of one price doesn’t hold, then If the law of one price doesn’t hold, then

its extension absolute PPP should not its extension absolute PPP should not be expected to hold, either.be expected to hold, either.

3838

Transport CostsTransport Costs

If a computer costs $1000 in the US and FF5000 in If a computer costs $1000 in the US and FF5000 in France, transportation costs could keep the France, transportation costs could keep the exchange rate different than FF5 per USD, the PPP exchange rate different than FF5 per USD, the PPP rate.rate.

If it costs $50 to ship the computer from the US to If it costs $50 to ship the computer from the US to France, and the exchange rate is FF4 per USD, a France, and the exchange rate is FF4 per USD, a French importer has to pay FF4000 + FF200.French importer has to pay FF4000 + FF200.

If the exchange rate is FF4.80 per $, the computer If the exchange rate is FF4.80 per $, the computer will cost FF4800 + FF240: no trade.will cost FF4800 + FF240: no trade.

If the exchange rate is FF4.75, the cost will be If the exchange rate is FF4.75, the cost will be FF4750+FF237.50 and trade will take place.FF4750+FF237.50 and trade will take place.

3939

TariffsTariffs Instead of the transport costs, if the French Instead of the transport costs, if the French

had 5% import tariff, the previous had 5% import tariff, the previous calculations would still be true.calculations would still be true.

There would be no exports of computers There would be no exports of computers from US to France if FF4.77 per USD or from US to France if FF4.77 per USD or above.above.

There would be no exports of computers There would be no exports of computers from France to US until the exchange rate from France to US until the exchange rate were above FF5.26 per USD.were above FF5.26 per USD.FF5000/5.26 = $950.57 for the computer plus FF5000/5.26 = $950.57 for the computer plus

$50 transportation.$50 transportation.

4040

NontradablesNontradablesThere is a range of exchange rates within There is a range of exchange rates within

which transportation costs prohibit trade.which transportation costs prohibit trade.The higher the transport costs, the more The higher the transport costs, the more

likely a good or service becomes likely a good or service becomes nontradable.nontradable.

The more nontradables in a country’s The more nontradables in a country’s basket of goods and services included in basket of goods and services included in the price calculation, the less the the price calculation, the less the probability of PPP holding.probability of PPP holding.

4141

NontradablesNontradables The prices of nontradables are determined The prices of nontradables are determined

through the interaction of domestic supply and through the interaction of domestic supply and demand.demand.

The higher the prices of nontradables, the The higher the prices of nontradables, the higher will be CPI or PPI, and the lower will be higher will be CPI or PPI, and the lower will be the purchasing power of a currency, lowering the purchasing power of a currency, lowering the standard of living.the standard of living.

In LDCs where there is a huge informal sector In LDCs where there is a huge informal sector that employs most of the urban populations, that employs most of the urban populations, prices of nontradables can be very low.prices of nontradables can be very low.

4242

NontradablesNontradables If services plus construction comprise a If services plus construction comprise a

large percentage of GDP (3/5 in US), large percentage of GDP (3/5 in US), baskets will not satisfy PPP.baskets will not satisfy PPP.

Even if the weights of different items in Even if the weights of different items in the CPI were the same in both the CPI were the same in both countries, a land scarce country like countries, a land scarce country like Hong Kong, Japan or Singapore will Hong Kong, Japan or Singapore will have a higher impact of nontradable have a higher impact of nontradable housing prices than US.housing prices than US.

4343

Imperfect MarketsImperfect Markets For PPP to hold, markets have to be For PPP to hold, markets have to be

competitive.competitive. If markets are segmented so that the If markets are segmented so that the

same producer can charge different same producer can charge different prices in different markets, there is no prices in different markets, there is no reason for the law of one price to hold.reason for the law of one price to hold.

Likewise, monopolistic or oligopolistic Likewise, monopolistic or oligopolistic market power will make prices higher market power will make prices higher than competitive prices, undermining than competitive prices, undermining PPP.PPP.

4444

CPI WeightsCPI Weights Depending on consumer tastes, mobility of Depending on consumer tastes, mobility of

the population, settlement patterns, the population, settlement patterns, different items entering into the consumer different items entering into the consumer basket will get different weights.basket will get different weights.

This further undermines the PPP.This further undermines the PPP. However, if all the prices had increased by However, if all the prices had increased by

the same percentage, weights would not the same percentage, weights would not matter in relative PPP. Currency would matter in relative PPP. Currency would depreciate by the same percentage.depreciate by the same percentage.

4545

CPI WeightsCPI Weights If relative prices between goods had If relative prices between goods had

changed, then relative PPP could not be changed, then relative PPP could not be satisfied.satisfied.

If fish prices rose worldwide, it would If fish prices rose worldwide, it would have a larger impact on Japanese CPI have a larger impact on Japanese CPI than on US CPI.than on US CPI.

4646

Balassa-Samuelson TheoryBalassa-Samuelson Theory Productivity in tradable sector is higher in the Productivity in tradable sector is higher in the

rich countries.rich countries. Productivity in the nontradables sector does Productivity in the nontradables sector does

not diverge between the rich and the poor not diverge between the rich and the poor countries.countries.

Average wages (reflecting average Average wages (reflecting average productivity) are higher in rich countries to productivity) are higher in rich countries to make nontradables prices higher.make nontradables prices higher.

Price levels in rich countries, therefore, are Price levels in rich countries, therefore, are higher.higher.

4747

Bhagwati-Kravis-Lipsey TheoryBhagwati-Kravis-Lipsey TheoryRich countries have high capital-labor Rich countries have high capital-labor

ratios.ratios.Marginal productivity in rich countries is, Marginal productivity in rich countries is,

therefore, higher resulting in higher therefore, higher resulting in higher wages.wages.

Nontradables are primarily labor-Nontradables are primarily labor-intensive, cheaper labor from poor intensive, cheaper labor from poor countries keep their prices lower in poor countries keep their prices lower in poor countries, lowering the price level.countries, lowering the price level.

4848

The Real Exchange RateThe Real Exchange Rateqq$/¥$/¥ = ($/¥) (P = ($/¥) (P¥¥/P/P$$))qq$/¥ $/¥ = ($ per ¥) times P= ($ per ¥) times P¥ ¥ per Japanese basket per Japanese basket

divided by Pdivided by P$$ per US basket = ($/¥) (P per US basket = ($/¥) (P¥¥/P/P$$) ) US basket per Japanese basket.US basket per Japanese basket.

(($/¥) P(($/¥) P¥¥ /Jb)/(P /Jb)/(P$$ /USb) = (($/¥) P /USb) = (($/¥) P¥¥ USb/ P USb/ P$$ Jb = (($/¥) PJb = (($/¥) P¥¥ / P / P$$ ) (USb/Jb) = q ) (USb/Jb) = q$/¥$/¥ USb per USb per JbJb

The real exchange rate shows the USD The real exchange rate shows the USD price of Japanese basket relative to the US price of Japanese basket relative to the US basket.basket.

4949

The Real Exchange RateThe Real Exchange Rate

If PPP were to hold always, the real If PPP were to hold always, the real exchange rate would be always one.exchange rate would be always one.

Because PPP hardly holds, the real Because PPP hardly holds, the real exchange rate deviates from one.exchange rate deviates from one.

The real exchange rate is the nominal The real exchange rate is the nominal exchange rate adjusted for the price exchange rate adjusted for the price levels in both countries.levels in both countries.

5050

Real Exchange RatesReal Exchange Rates

An increase in qAn increase in q$/¥ $/¥ is a real depreciation of is a real depreciation of

USD.USD. It can happen by nominal depreciation of It can happen by nominal depreciation of

USD or increase in Japanese price level or USD or increase in Japanese price level or drop in US price level.drop in US price level.Reread the sentence above. It is contrary to Reread the sentence above. It is contrary to

relative PPP.relative PPP.

5151

The Real Exchange RateThe Real Exchange RateWhen the qWhen the q$/¥$/¥ rises, the dollar’s rises, the dollar’s

purchasing power over Japanese goods purchasing power over Japanese goods and services falls relative to its and services falls relative to its purchasing power over US goods and purchasing power over US goods and services.services.

America’s goods and services become America’s goods and services become cheaper relative to Japan.cheaper relative to Japan.

A rise in qA rise in q$/¥$/¥ is of course a real is of course a real

depreciation of USD.depreciation of USD.

5252

Real Exchange Rates and PPPReal Exchange Rates and PPP

If real exchange rates do not comply If real exchange rates do not comply with absolute PPP, i.e., qwith absolute PPP, i.e., q$/¥$/¥ does not does not

necessarily equal to 1, then relative necessarily equal to 1, then relative price level changes will affect the real price level changes will affect the real exchange rate.exchange rate.Relative price levels can change because Relative price levels can change because

of demand or supply changes.of demand or supply changes.

qq$/¥ $/¥ = $/¥ (P= $/¥ (PJJ/P/PUSUS))

5353

Demand for Japanese Demand for Japanese Products IncreasesProducts Increases

If total world spending on Japanese goods If total world spending on Japanese goods and services rises relative to that of and services rises relative to that of American G&S, there will be excess American G&S, there will be excess demand for Japanese products at the demand for Japanese products at the original real exchange rate.original real exchange rate.

The relative price of Japanese output in The relative price of Japanese output in terms of US basket has to rise or the terms of US basket has to rise or the amount of US basket per Japanese basket amount of US basket per Japanese basket has to increase.has to increase.

5454

Demand for Japanese Products Demand for Japanese Products IncreasesIncreases

qq$/¥ $/¥ = ($ per ¥) times P= ($ per ¥) times P¥ ¥ per Japanese per Japanese

basket divided by Pbasket divided by P$$ per US basket = ($/¥) per US basket = ($/¥)

(P(P¥¥/P/P$$) US basket per Japanese basket.) US basket per Japanese basket.

qq$/¥ $/¥ rises.rises.Real appreciation of yen takes place.Real appreciation of yen takes place.A drop in the world demand for US A drop in the world demand for US

products cause a real depreciation of products cause a real depreciation of USD.USD.

5555

Relative Output SupplyRelative Output SupplySuppose productivity of US labor and Suppose productivity of US labor and

capital increases.capital increases.There will be an excess supply of American There will be an excess supply of American

goods and services at the original qgoods and services at the original q$/¥ $/¥ ..The relative price of American basket falls. The relative price of American basket falls.

US basket per Japanese basket is larger.US basket per Japanese basket is larger.qq$/¥ $/¥ rises: ($ per ¥) times Prises: ($ per ¥) times P¥ ¥ per Japanese per Japanese

basket divided by Pbasket divided by P$$ per US basket = ($/¥) per US basket = ($/¥)

(P(P¥¥/P/P$$) US basket per Japanese basket.) US basket per Japanese basket.

5656

Productivity IncreaseProductivity Increase

Higher productivity increase in a country Higher productivity increase in a country causes a real depreciation of its causes a real depreciation of its currency in the long run.currency in the long run.

Higher demand for a country’s output Higher demand for a country’s output causes a real appreciation of its causes a real appreciation of its currency in the long run.currency in the long run.

5757

Nominal and Real Exchange RatesNominal and Real Exchange Rates If qIf q$/¥ $/¥ = ($/¥) (P= ($/¥) (P¥¥/P/P$$), then ($/¥) = q), then ($/¥) = q$/¥ $/¥ (P(P$$/P/P¥¥). ). Nominal exchange rate of USD per yen is Nominal exchange rate of USD per yen is

equal to real exchange rate of USD per yen equal to real exchange rate of USD per yen times relative US price level to Japanese times relative US price level to Japanese price level.price level.

Recall the monetary approach to FX Recall the monetary approach to FX determination where PPP was assumed to determination where PPP was assumed to hold: ($/¥) = (Phold: ($/¥) = (P$$/P/P¥¥). ).

By including the qBy including the q$/¥ $/¥ we can drop the PPP we can drop the PPP

requirement. requirement.

5858

Nominal and Real Exchange RatesNominal and Real Exchange Rates

($/¥) = q($/¥) = q$/¥ $/¥ (P(P$$/P/P¥¥) implies that) implies that for a given real USD per yen exchange for a given real USD per yen exchange

rate, money supply and demand in each rate, money supply and demand in each country will determine the price levels and, country will determine the price levels and, hence, nominal $ per yen rate.hence, nominal $ per yen rate.

Given price levels, changes in the real $ Given price levels, changes in the real $ per yen rate also affects the nominal rate.per yen rate also affects the nominal rate.

5959

Long Run Nominal Exchange RateLong Run Nominal Exchange Rate Change Effect on $/¥Money SectorIncrease in US M Proportional increaseIncrease in Japanese M Proportional decreaseIncrease in US money growth IncreaseIncrease in Japanese money growth DecreaseReal SectorIncrease in demand for US output DecreaseIncrease in demand for Japanese output IncreaseOutput supply increase in US AmbiguousOutput supply increase in Japan Ambiguous

6060

A Shift in Relative Money A Shift in Relative Money Supply LevelsSupply Levels

Suppose Japanese money supply has a Suppose Japanese money supply has a permanent one-time increase.permanent one-time increase.

In the long run, there should be no change In the long run, there should be no change in real values; only nominal values should in real values; only nominal values should change.change.

Furthermore, there should be no change in Furthermore, there should be no change in the interest rate. Graph this.the interest rate. Graph this.

6161


M/P

R Real money supply

R0

R1

In the long runprice level will rise proportionately to money increase.

6262


Along with other real variables, real Along with other real variables, real exchange rate does not change, either.exchange rate does not change, either.

[M[Mss/L(Y,R)]/L(Y,R)]JJ = P = P¥¥

($/¥) = q($/¥) = q$/¥ $/¥ (P(P$$/P/P¥¥))

If PIf P¥¥ rises at the same proportion as rises at the same proportion as

Japanese money supply, the nominal Japanese money supply, the nominal exchange rate ($/¥) should fall.exchange rate ($/¥) should fall.

6363

A Shift in Money Growth RatesA Shift in Money Growth RatesA permanent increase in the US money A permanent increase in the US money

growth rate raises the US inflation, and growth rate raises the US inflation, and through the Fisher effect, raises the dollar through the Fisher effect, raises the dollar interest rate.interest rate.

US price level has to rise to keep the money US price level has to rise to keep the money demand equal to money supply.demand equal to money supply.

USD returns from yen deposits increase USD returns from yen deposits increase because USD is expected to depreciate.because USD is expected to depreciate.

Slide #26.Slide #26.

6464

A Shift in Money Growth RatesA Shift in Money Growth RatesThe change is monetary; it is neutral in The change is monetary; it is neutral in

long run real variable effects.long run real variable effects.Real exchange rate does not change.Real exchange rate does not change. ($/¥) = q($/¥) = q$/¥ $/¥ (P(P$$/P/P¥¥) implies the rise in the ) implies the rise in the

price level of US has to be matched by price level of US has to be matched by the depreciation of USD.the depreciation of USD.

6565

A Change in Relative Output DemandA Change in Relative Output Demand

National price levels will only respond to National price levels will only respond to demand and supply of money.demand and supply of money.

[M[Mss/L(Y,R)]/L(Y,R)]USUS = P = P$ $ and [Mand [Mss/L(Y,R)]/L(Y,R)]JJ = P = P¥¥

Demand changes, therefore, will not affect Demand changes, therefore, will not affect price levels.price levels.

A relative increase in demand for US output A relative increase in demand for US output will raise the Japanese basket per US basket.will raise the Japanese basket per US basket.

Alternatively, it will decrease the US basket Alternatively, it will decrease the US basket per Japanese basket.per Japanese basket.

6666

A Change in Relative Output DemandA Change in Relative Output Demand

qq$/¥ $/¥ = ($ per ¥) times P= ($ per ¥) times P¥ ¥ per Japanese basket per Japanese basket

divided by Pdivided by P$$ per US basket = ($/¥) (P per US basket = ($/¥) (P¥¥/P/P$$) US ) US

basket per Japanese basket.basket per Japanese basket. qq$/¥ $/¥ falls.falls. Real depreciation of yen against the USD.Real depreciation of yen against the USD. Real appreciation of USD against the yen.Real appreciation of USD against the yen. ($/¥) = q($/¥) = q$/¥ $/¥ (P(P$$/P/P¥¥) implies that nominal ) implies that nominal

exchange rate of yen falls and USD exchange rate of yen falls and USD appreciates.appreciates.

6767

A Change in Relative Output SupplyA Change in Relative Output Supply

A relative increase in Japanese output due to A relative increase in Japanese output due to productivity increases means the Japanese are productivity increases means the Japanese are willing to exchange a higher amount of their willing to exchange a higher amount of their basket for US goods.basket for US goods.

The US basket per Japanese basket The US basket per Japanese basket decreases.decreases.

qq$/¥ $/¥ = ($ per ¥) times P= ($ per ¥) times P¥ ¥ per Japanese basket per Japanese basket

divided by Pdivided by P$$ per US basket = ($/¥) (P per US basket = ($/¥) (P¥¥/P/P$$) US ) US

basket per Japanese basket.basket per Japanese basket. Real depreciation of yen: qReal depreciation of yen: q$/¥ $/¥ falls.falls.

6868

A Change in Relative Output SupplyA Change in Relative Output Supply

Productivity increase in Japan raises Productivity increase in Japan raises their income, Y.their income, Y.

The real demand for money rises.The real demand for money rises. [M[Mss/L(Y,R)]/L(Y,R)]JJ = P = P¥ ¥ implies P implies P¥ ¥ has to fall.has to fall.

($/¥) = q($/¥) = q$/¥ $/¥ (P(P$$/P/P¥¥) nominal exchange ) nominal exchange

rate will respond to the fall of qrate will respond to the fall of q$/¥ $/¥ and and

fall of Pfall of P¥¥.. ($/¥) may increase or decrease. ($/¥) may increase or decrease.

6969

Summary of Money and Real Sector Summary of Money and Real Sector Disturbances in the Long RunDisturbances in the Long Run

When disturbances are monetary, long run When disturbances are monetary, long run nominal exchange rates obey relative nominal exchange rates obey relative PPP; real exchange rates do not change.PPP; real exchange rates do not change.

When disturbances are from output When disturbances are from output markets, the nominal exchange rates do markets, the nominal exchange rates do not obey the relative PPP; real exchange not obey the relative PPP; real exchange rates do change.rates do change.

7070

($/¥) Rate During the Last 50 Years($/¥) Rate During the Last 50 Years

Between 1950 and 1971 the nominal rate of yen Between 1950 and 1971 the nominal rate of yen was fixed at ¥360 per $ or $0.00278 per ¥.was fixed at ¥360 per $ or $0.00278 per ¥.

The real exchange rate qThe real exchange rate q$/¥$/¥ however, rose however, rose

because Japan had higher inflation rate than US.because Japan had higher inflation rate than US. In the seventies the nominal exchange rate In the seventies the nominal exchange rate

became flexible.became flexible. Inflation in US on average was higher than Inflation in US on average was higher than

Japanese inflation the last 25 years.Japanese inflation the last 25 years.

7171


The qThe q$/¥ $/¥ rate should have been falling if the rate should have been falling if the

nominal exchange rate was fixed,nominal exchange rate was fixed, ($/¥) = q($/¥) = q$/¥ $/¥ (P(P$$/P/P¥¥). Both nominal and real ). Both nominal and real

rates rose.rates rose.The reason for the rise of qThe reason for the rise of q$/¥ $/¥ (US basket per (US basket per

Japanese basket) was the much higher Japanese basket) was the much higher productivity increase in tradables in Japan productivity increase in tradables in Japan that raised the price level for nontradables.that raised the price level for nontradables.

7272


qq$/¥ $/¥ = ($ per ¥) times P= ($ per ¥) times P¥ ¥ per Japanese per Japanese

basket divided by Pbasket divided by P$$ per US basket = per US basket =

($/¥) (P($/¥) (P¥¥/P/P$$) US basket per Japanese ) US basket per Japanese

basket.basket. ($/¥) = q($/¥) = q$/¥ $/¥ (P(P$$/P/P¥¥) implies that the ) implies that the

nominal exchange rate will rise because nominal exchange rate will rise because of an increase in qof an increase in q$/¥ $/¥ and a higher and a higher

inflation in US. inflation in US. The rate is about ¥120 per $.The rate is about ¥120 per $.

7373

Interest Rates and Real Exchange Interest Rates and Real Exchange Rates with ExpectationsRates with Expectations

qq$/¥ $/¥ = ($/¥) (P= ($/¥) (P¥¥/P/P$$).).

%%qq$/¥ $/¥ = %= %($/¥) + %($/¥) + %(P(P¥¥/P/P$$).).

(q(qe e - q)/q = [{($/¥)- q)/q = [{($/¥)ee - ($/¥)}/ ($/¥)] + [(P - ($/¥)}/ ($/¥)] + [(P¥¥ee - -

PP¥¥)/ P)/ P¥¥] - [(P] - [(P$$ee

-P-P$$)/P)/P$$].].

(q(qe e - q)/q = [(E- q)/q = [(Eee - E)/E] + [ - E)/E] + [¥¥ee] - [] - [$$

ee ].].

Remember interest parity.Remember interest parity.

7474

Interest Rates and Real Exchange Interest Rates and Real Exchange Rates with ExpectationsRates with Expectations

RR$$ = R = R¥¥ + [(E + [(Eee - E)/E]. - E)/E].

RR$$ - R - R¥¥ = [(E = [(Eee - E)/E]. - E)/E].

Therefore, RTherefore, R$$ - R - R¥¥ = (q = (qe e - q)/q + (- q)/q + ($$ee - - ¥¥

ee).). If US inflation is 3% higher than Japanese If US inflation is 3% higher than Japanese

inflation and the demand and supply inflation and the demand and supply conditions require 2% real appreciation of the conditions require 2% real appreciation of the yen, then the interest rate differential will be yen, then the interest rate differential will be 5%.5%.

7575

Real Interest RatesReal Interest Rates rr$$

ee = R = R$$ - - $$ee

rr¥¥e e = R= R¥¥ - - ¥¥

ee

RR$$ - R - R¥¥ = (q = (qe e - q)/q + (- q)/q + ($$ee

- - ¥¥ee).).

rr$$ee - r - r¥¥

e e = (R= (R$$ - - $$ee) - (R) - (R¥¥ - - ¥¥

ee) )

rr$$ee - r - r¥¥

e e = (q= (qe e - q)/q - q)/q Interest parity holds with real interest Interest parity holds with real interest

rates and real exchange rates.rates and real exchange rates.

1 ch. 15: price levels and the exchange rate in the long run

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