copyright © 2006 pearson addison-wesley. all rights reserved. 15-1 chapter 15 price levels and the...

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 15-1

Chapter 15

Price Levels and the Exchange Rate

in the Long Run


1. Preview

• Two Approaches to the Determination of FOREX Rate or E

1) Purchasing Power Parity Theory: ‘Monetary Approach’ or ‘Monetarist Approach”

2) Real Exchange Rate Analysis : Real Factor Analysis

• Both are Long -un models of exchange rates


2. Purchasing Power Parity: 1) Fundamental Force

Assuming that there is an equilibrating force built into the world market economy, which will set the equilibrium FOREX rates in such a way that a fixed amount of a currency (say, Canadian $) may buy the same amount of goods anywhere in the world after the currency conversion.


2) The ‘new PPP’ comes from the old ‘Law of One Price for One Good’

• 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 markets are not important.


3) Formally, Purchasing Power Parity

• 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.

(ECanada$/us$) PUS = (PCanada)

PUS = price level of goods and services in the US

PCanada = price level of goods and services in Canada

ECanada$/us$ = exchange rate


• PPP implies that

ECanada$/us$ = PCanada / PUS

The price levels adjust to determine the exchange rate.

If the price level in the US is US$200 per basket, while the price level in Canada is C$300 per basket, PPP implies that the C$ /US$ exchange rate should be C$300/US$200 = C$ 1.5 / US$ 1 = E c$/us$.

Purchasing power parity says that each country’s currency has the same purchasing power: 1.5 Canadian dollars buy the same amount of goods and services as does 1 US dollar, since prices in Canada are 50% as high.


4) Two Versions of Purchasing Power Parity

• Purchasing power parity comes in 2 forms:

• Absolute PPP: purchasing power parity that has already been discussed. Exchange rates equal price levels across countries.

E$/€ = P$/PEU

• Relative PPP: changes in exchange rates equal changes in prices (inflation rates)

%E$/€, = $ - EU,

where t = inflation rate


5) Purchasing Power Parity assumes

E$/€ = P$/PEU

E$/€ / (P$/PEU)=1 at all times

*Question: If the PPP holds in reality, what would be the graphs of the relative price data, Money supplies of two countries and the FOREX rate like?


6) PPP is also called ‘Monetary Approach’

Holds in Long-run. In particular, FOREX rate is determined by

the relative price level, which is proportional to relative money supply of the two countries.

Assuming no changes in real factors such as demand or supply of goods; the only change is due to money suppies and the price levels.


Monetary Approach to Exchange Rates (cont.)

• The exchange rate is determined in the long run by relative prices (P/P), which are determined by the relative supply of money across countries across countries.


A Simple Math Express is:

1) Absolute PPP:

E$/€ = P$/PEU =

2) Relative PPP:

%E$/€, = $ - EU = %MS$- %MSEU


* Monetary Approach to Exchange Rates: Combine PPP and the Long-run Money-Price Relationshipa permanent rise in the domestic money supply

causes a proportional increase in the domestic price level in the long-run;

causing a proportional depreciation in the domestic currency (through PPP).


* Expectations and Depreciation feed back to the Short-run Model through the FOREX Market.

• If the above is repeated, now people form expectations, linking money creation to depreciation immediately. People develop an Expected Rise in FOREX Rate.

• Now going back to the Short-run Interest Parity Model(Chapter 13): In the Financial Market, Expectations of Depreciation of Domestic Currency cause the Expected Return on Foreign Investment to increase, acutally making the domestic currency depreciate immediately.


7) Shortcomings of PPP

• There is little empirical support for 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 performs poorly to predict exchange rates.


Shortcomings of PPP (cont.)



Reasons why PPP may not be a good theory:

1. Trade barriers and non-tradable goods and services

2. Imperfect competition

3. Differences in price level measures



• Trade barriers and non-tradables Transport costs and governmental trade

restrictions make trade expensive and in some cases create non-tradable goods or services.

Services are often not tradable: services are generally offered within a limited geographic region (e.g., haircuts).

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.



• Imperfect competition may result in price discrimination: “pricing to market”. 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.

• Differences in price level measures price levels differ across countries because of the way

representative groups (“baskets”) of goods and services are measured.

Because measures of goods and services are different, the measure of their prices need not be the same.


2. The Real Exchange Rate Approach to Exchange Rates

1) Introducing Real Factors

• According to PPP, exchange rates are determined by relative price ratios:

E$/ € = P$/P€

• According to the more general real exchange rate approach, exchange rates may also be influenced by the real exchange rate:

E$/ € = q$/ € x P$/P €, and q is not constant at 1.


2) Simple Definition of Real Exchange Rate

By definition, on surface,

q$/EU = (E$/€ x PEU)/P$

This is the simple definition of real exchange rate.

This is the real domestic currency price of foreign currency.

When this falls, there is a real depreciation of FOREX, and a real appreciation of domestic currency.


3) Changes in q: What do we call?Example) Real Deprecation of FOREX or Real Appreciation of Domestic Currency

q $/EU = (E$/€ x PEU)/P$

If the EU basket costs €100, the Canadian basket costs $120 and the nominal exchange rate is $1.20 per euro, then the real exchange rate is 1.

If the EU basket costs €100, the Canadian basket costs $120 and the nominal exchange rate is $1.00 per euro, then the real exchange rate is 0.82.

When q goes down, we say that there is a real depreciation of FOREX or a real appreciation of domestic currency: We say that the international competitiveness of domestic good increases.


Real Exchange Rate Analysis of FOREX Rate:

Note that E and q go move together in this case.

E is determined by q, and q is determined by Real Factors.


3) Complex Function of Real Exchange Rate

What influences the real exchange rate?

Relative Sizes of International Demand and Domestic Supply that affect Supply of and Demand for FOREX in the country

q = f( International Excess Demand(-);

Increased Domestic Supply to the World(-))

= f (Net Exports(-))

= f (Net Demand for Domestic Goods)

=f (Net Supply of FOREX)

=f(Current Account Surplus)


* Japan in the 1970s and 80s.

• International Demand

• Japanese Supply – Technical Innovation

• Current Account Surplus

• E

• q

copyright © 2006 pearson addison-wesley. all rights reserved. 15-1 chapter 15 price levels and the...

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