CHAPTER 15 PRICE LEVELS AND THE EXCHANGE RATE IN THE

LONG RUN

PRICE LEVELS AND THE EXCHANGE RATE IN THE LONG RUN

What economic forces lie behind the long-What economic forces lie behind the long-term movements in exchange rate?term movements in exchange rate?

What kind linkage is among monetary What kind linkage is among monetary policies ,inflation, interest rate and policies ,inflation, interest rate and exchange rate?exchange rate?

THE LAW OF ONE PRICE

When trade is open and costless, identical When trade is open and costless, identical goods must trade at the same relative prices goods must trade at the same relative prices regardless of where they are sold.regardless of where they are sold.

PPiius us =(E=(E$/€$/€)*(P)*(Pii

EE))

EE$/€$/€ = P = Piiusus / P / Pii

EE

PURCHASING POWER PARITY

All countries’ price levels are equal when measured in term of the same All countries’ price levels are equal when measured in term of the same

currency.currency.

PPusus =(E =(E$/€$/€) * P) * PEE

The Relationship Between PPP and the Law of One Price

The law of one price applies to individual The law of one price applies to individual commodities, while PPP applies to the commodities, while PPP applies to the general price level, which is a composite of general price level, which is a composite of prices of all the commodities that enter into prices of all the commodities that enter into reference basket. reference basket.

Absolute PPP and Relative PPP

Relative PPP states that the percentage Relative PPP states that the percentage change in exchange rate between two change in exchange rate between two currencies over any period equals the currencies over any period equals the difference the percentage changes in difference the percentage changes in national price level.national price level.

(E(E$/€,t$/€,t-E-E$/€,t-1$/€,t-1)/ E)/ E$/€,t-1$/€,t-1=П=Пus,tus,t-П-ПE,tE,t

A LONG RUN EXCHANGE RATE MODEL BASED ON PPP

Monetary approach to exchange rateMonetary approach to exchange rate

we the variable’s equilibrium value in a we the variable’s equilibrium value in a hypothetical world of perfectly flexible hypothetical world of perfectly flexible output and factor market prices.output and factor market prices.

The Fundamental Equation of the Monetary Approach

EE$/€ $/€ = P= Pusus / P / PE E

PPus us = M= Mss

us us /L(R/L(R$$,Y,Yusus))

PPE E = M= Mss

E E / L(R/ L(R€€,Y,YEE))

the exchange rate, which is the relative price of the exchange rate, which is the relative price of American and European money, is fully American and European money, is fully determined in the long run by the relative supplies determined in the long run by the relative supplies of those money and the relative real demands for of those money and the relative real demands for them.them.

The Fundamental Equation of the Monetary Approach

Shifts in interest rate and output level affect Shifts in interest rate and output level affect the exchange rate only through their the exchange rate only through their influence on money demand.influence on money demand.

Money suppliesMoney supplies

Interest rateInterest rate

Output levelsOutput levels

Ongoing inflation,Interest Parity, and PPP

Money supply growth at a constant rate Money supply growth at a constant rate eventually results in ongoing price level eventually results in ongoing price level inflation at the same rate, but changes in inflation at the same rate, but changes in this long-run inflation rate do not affect the this long-run inflation rate do not affect the full-employment output level or the long-full-employment output level or the long-run relative prices of goods and services.run relative prices of goods and services.

Ongoing inflation,Interest Parity, and PPP

RR$$=R=R€€ +(E +(Eee

$/€$/€-E-E$/€$/€)/E)/E$/€$/€

RR$ $ -R-R€€ =П =Пee

usus-П-Пee

E E

If people expect relative PPP to hold, the If people expect relative PPP to hold, the difference between the inflation rates offered by difference between the inflation rates offered by dollar and euro deposits will equal the difference dollar and euro deposits will equal the difference between the inflation rates expected, over the between the inflation rates expected, over the relevant horizon, in the United States and in relevant horizon, in the United States and in Europe.Europe.

The Fisher Effect

All else equal, a rise in a country’s expected All else equal, a rise in a country’s expected inflation rate will eventually cause an equal inflation rate will eventually cause an equal rise in the interest rate that deposits of its rise in the interest rate that deposits of its currency offer. Similarly, a fall in the currency offer. Similarly, a fall in the expected inflation rate will eventually cause expected inflation rate will eventually cause a fall in the interest rate.a fall in the interest rate.

Figure 15-1 Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money Supply

€

Figure 15-1 (a)

M us , t 0

t 0Time

U.S. moneysupply,

M us

Figure 15-1 (d)

t 0 Time

Dollar/euroexchangerate, E $/€

Figure 15-1 (c)

t 0Time

U.S. pricelevel, P us

Figure 15-1 (b)

R $1

R $2

Time

Dollarinterestrate, R $

t

Figure 15-2 Inflation and Interest Rates in Switzerland, the United States and Italy, 1970-1997

Figure 15-2 continued...

Figure 15-2 continued...

Empirical Evidence on PPP and the Law of One Price

The Dollar/DM Exchange Rate and Relative U.S./German The Dollar/DM Exchange Rate and Relative U.S./German Price Levels, 1964-1997Price Levels, 1964-1997

EXPLAINING THE PROBLEMS WITH PPP

Contrary to the assumption of the law of one price, Contrary to the assumption of the law of one price, transport costs and restrictions on trade certainly do transport costs and restrictions on trade certainly do exist.exist.

Monopolistic or oligopolistic practices in goods Monopolistic or oligopolistic practices in goods markets may interact with transport costs and other markets may interact with transport costs and other trade barriers to weaken further the link between the trade barriers to weaken further the link between the prices of similar goods sold in different countries.prices of similar goods sold in different countries.

The inflation data reported in different countries are The inflation data reported in different countries are based on different commodity baskets.based on different commodity baskets.

Trade Barriers and Nontradables

The greater the transport costs, the greater The greater the transport costs, the greater the range over which the exchange rate can the range over which the exchange rate can move, given goods prices indifferent move, given goods prices indifferent counties.counties.

The existence in all countries of nontraded The existence in all countries of nontraded goods and services whose prices are not goods and services whose prices are not linked internationally allows systematic linked internationally allows systematic deviations even from relative PPPdeviations even from relative PPP

Departure from Free Competition

The combination of product differentiation The combination of product differentiation and segmented markets, however, leads to and segmented markets, however, leads to large violations of the law of price and large violations of the law of price and absolute PPP.absolute PPP.

Shifts in market structure and demand over Shifts in market structure and demand over time can invalidate relative PPP time can invalidate relative PPP

International differences in price level measurement

Because relative PPP makes predictions Because relative PPP makes predictions about price changes rather than price levels, about price changes rather than price levels, it is a sensible concept regardless of the it is a sensible concept regardless of the baskets used to define price levels in the baskets used to define price levels in the countries being compared.countries being compared.

PPP in the Short Run and in the Long Run

Many prices in the economy are sticky and Many prices in the economy are sticky and take time to adjust fully. Departures from take time to adjust fully. Departures from PPP may therefore be even greater in the PPP may therefore be even greater in the short run than in the long run.short run than in the long run.

Floating exchange rates systematically lead Floating exchange rates systematically lead to much larger and more frequent short-run to much larger and more frequent short-run deviations from relative PPP.deviations from relative PPP.

BEYOND PURCHASING POWER PARITY: A GENERAL MODEL OF LONG-RUN EXCHANGE RATES

PPP theory is the basic idea of long-run PPP theory is the basic idea of long-run exchange rates to long-run national price exchange rates to long-run national price levels, but relevant model is too simple and levels, but relevant model is too simple and predicts badly in practice.predicts badly in practice.

The Real Exchange Rate

The United States price level will place a The United States price level will place a relatively heavy weight on commodities relatively heavy weight on commodities produced and consumed in America, the produced and consumed in America, the European price level a relatively heavy European price level a relatively heavy weight on commodities produced and weight on commodities produced and consumed in Europe.consumed in Europe.

qq$/€$/€=(E =(E $/€$/€*P*PE E )/P)/PUSUS

Demand, Supply, and the Long-run Real Exchange Rate

A change in world relative demand for American A change in world relative demand for American products.products. An increase in world relative demand for US An increase in world relative demand for US

output causes a long-run real appreciation of output causes a long-run real appreciation of the dollar against the euro(a fall in the dollar against the euro(a fall in qq$/€$/€).similarly, a fall in world relative demand ).similarly, a fall in world relative demand

for US output causes a long-run real for US output causes a long-run real depreciation of the dollar against the euro (a depreciation of the dollar against the euro (a rise in qrise in q$/€$/€) )

Demand, Supply, and the Long-run Real Exchange Rate

A change in relative output supply.A change in relative output supply. A relative expansion of US output causes A relative expansion of US output causes

a long-run real depreciation of the dollar a long-run real depreciation of the dollar against the euro (qagainst the euro (q$/€ $/€ rises). A relative rises). A relative

expansion of European output causes a expansion of European output causes a long-run real appreciation of the dollar long-run real appreciation of the dollar against the euro (qagainst the euro (q$/€ $/€ falls). falls).

Nominal and Real Exchange Rates in long-run Equilibrium

qq$/€$/€=(E=(E$/€$/€*P*PEE)/P)/PUSUS

EE$/€$/€=q=q$/€$/€*(P*(PUSUS/P/PE E )) The equation implies that for a given real The equation implies that for a given real

dollar/euro exchange rate, changes in money dollar/euro exchange rate, changes in money demand or supply in Europe or the United States demand or supply in Europe or the United States affect the long-run nominal dollar/euro exchange affect the long-run nominal dollar/euro exchange rate as in the monetary approach. Changes in the rate as in the monetary approach. Changes in the long-run real exchange rate, however, also affect long-run real exchange rate, however, also affect the long-run nominal exchange rate.the long-run nominal exchange rate.

Nominal and Real Exchange Rates in long-run Equilibrium

A shift in relative money supply levels.A shift in relative money supply levels. A shift in relative money supply growth A shift in relative money supply growth

rates.rates. A change in relative output demand.A change in relative output demand. A change in relative output supply.A change in relative output supply.

INTERNATIONAL INTEREST RATE DIFFERENCES AND THE REAL EXCHANGE RATE

Interest rate differences between countries Interest rate differences between countries depend not only on differences in expected depend not only on differences in expected inflation, as the monetary approach asserts, inflation, as the monetary approach asserts, but also expected changes in the real but also expected changes in the real exchange rate.exchange rate.

RR$$-R-R€€=[(q=[(qee

$/€$/€ -q -q$/€$/€)/q)/q$/€$/€]+ (П]+ (Пee

usus-П-Пee

E E ))

Real Interest Parity

The rates of return measured in real The rates of return measured in real

terms, that is , in terms of a country’s terms, that is , in terms of a country’s

output.output.

rree

USUS-r-ree

E E =(q=(qee

$/€$/€ -q -q$/€$/€)/q)/q$/€$/€

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