reinert/windows on the world economy, 2005 exchange rates and purchasing power parity chapter 13
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Reinert/Windows on the World Economy, 2005
Exchange Rates and Purchasing Power Parity
CHAPTER 13
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Introduction
Exchange rates matter in many different ways to many different constituencies in the world economy
Much of this section on international finance will be directly or indirectly concerned with exchange rates
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The Nominal Exchange Rate
Relative price of two currencies Often expressed as number of units of local or home currency
required to buy a unit of foreign currency
We will usually view Mexico (peso) as our home country and United States (dollar) as our foreign country
Nominal or currency exchange rate (e) is
If e increases the value of the peso (home currency) falls If e decreases the value of the peso (home currency) rises e and the value of the peso are inversely related
• e is often graphed as its inverse which is equal to the value of the peso
dollar
pesos
currencyforeign
currencylocale
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Table 13.1. Nominal Exchange Rates, October 9, 2002 (per US dollar)
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Figure 13.1. The Value of the Peso Scale
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The Real Exchange Rate
Measures the rate at which two countries’ goods trade against each other
Makes use of the price levels in the two countries under consideration PM—overall price level in Mexico (the home
country) PUS—overall price level in the United States (the
foreign country)
M
US
P
Pere
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Table 13.2. Changes in the Real Exchange Rate
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The Real Exchange Rate
Suppose that the price level in the United States rises Takes more Mexican goods to purchase US goods Represents a fall in the real value of the peso
Suppose that the price level in Mexico rises Takes fewer Mexican goods to purchase US goods Represents a rise in the real value of the peso
Suppose that the nominal exchange rate increases Takes more Mexican pesos to buy a US dollar and, therefore, more
Mexican goods to buy US goods Represents a fall in the real value of the peso
Real exchange rates affected by both nominal exchange rates and price levels
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Exchange Rates and Trade Flows
Changes in e have an impact on trade flows Consider the case of Mexico’s imports and exports
World prices (PW) are typically in US dollar terms Mexican prices (PM) are in peso terms
• Relationship between the peso and world prices of Mexico’s import (Z) goods can be expressed as
WZ
MZ PeP
• is in dollar terms Multiplying it by e gives us in peso terms
WZP
MZP
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Exchange Rates and Trade Flows
Suppose e were to increase (the value of the peso falls) Movement down the scale in Figure 13.1 increases the
peso price of the imported good in Mexico Import demand consequently decreases
Suppose e were to decrease (the value of the peso rises) Movement up the scale in Figure 13.1 decreases the
peso price of the imported good in Mexico Import demand consequently increases
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Figure 13.2. The Value of the Peso and Mexico’s Imports
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Figure 13.3. The Value of the Peso and Mexico’s Exports
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Exchange Rates and Trade Flows
Relationship between the peso and dollar prices of Mexico’s exported (E) goods can be expressed as
Suppose e were to increase (the value of the peso falls) Movement down the scale in Figure 13.1 increases the
peso price of the export good in Mexico Export supply in Mexico consequently increases
• Mexican firms now have more of an incentive in peso terms to export
WE
ME PeP
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Exchange Rates and Trade Flows
Suppose e were to decrease (the value of the peso rises) Movement up the inverse scale in Figure 13.1
decreases the peso price of exports in Mexico Export supply consequently decreases
Can put the relationships of Figures 13.2 and 13.3 together Figure 13.4 represents the positive relationship
between value of peso and trade deficit, or Z – E
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Figure 13.4. The Value of the Peso and Mexico’s Trade Deficit
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The Purchasing Power Parity Model
Begins with the hypothesis that the nominal exchange rate will adjust so that the purchasing power of a currency will be the same in every country
Implications of hypothesis Purchasing power of a currency in a given country is inversely related to
price level in that country• For example, purchasing power of the peso in Mexico can be expressed as
The higher the price level in Mexico the lower the purchasing power of the peso
Purchasing power of peso in United States is more complicated• Need rate at which a peso can be exchanged into dollars, or 1/e• Need purchasing power of a dollar in United States, or 1/PUS
• Purchasing power of a peso in United States is
MP1
USPe11
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PPP Equation
PPP hypothesis is
Invert the equation
Divide both sides of the above equation by PUS to obtain PPP equation
USM PeP
111
USM PeP
US
M
P
Pe
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Meaning of PPP Equation
Suppose PM were to increase According to the PPP model, e would increase
• Value of the peso would move down the scale in Figure 13.1
Suppose PUS were to increase According to the PPP model e would decrease
• Value of the peso would move up the scale in Figure 13.1
Nominal value of the peso adjusts to changes in its real purchasing power in the two countries
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Meaning of PPP Equation
Restrictiveness of PPP model can be seen when we re-express it in a third equation Multiplying both sides of the PPP equation by
Compare this equation with real exchange rate
Obtain modified PPP equation
M
US
PP
1M
US
P
Pe
reP
Pe
M
US
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PPP Model as Special Case
PPP model is a special case of the real exchange rate Implies that real exchange rate is fixed at unity
• No change in real exchange rate However real exchange rates do change therefore there
must be important elements of the real world that the PPP theory ignores
PPP assumes all goods entering into the price levels of both countries are internationally traded
Phenomenon of product differentiation Allows for separate markets (and therefore prices) for
import and domestic varieties of a good
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PPP Model as Special Case
Real exchange rate equation captures reality at any point in time PPP relationship never holds exactly
PPP equation gives a sense of a long-term tendency towards which nominal exchange rates move absent other changes
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Exchange Rate Exposure
If sales from either exporting or foreign direct investment are not denominated in the currencies of the firms’ home countries Exchange rate exposure issues arise
Suppose that the €/US$ exchange rate is currently at a value of 1.00
Suppose also that a US firm is expecting euro revenues of €1.0 million Current exchange rate (spot rate) suggests US firm might be
expecting dollar revenues of US$1.0 million Suppose, however, that the spot rate moves to e = 1.25 (a dollar
value of the euro of $0.80)• Now takes more euros to purchase a dollar—dollar revenues shrink to
$800,000
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Forward Markets
For some currencies forward rates also exist Rates of current contracts for “forward” transactions in currencies
• Usually for one, three, or six months in the future
If the forward rate of the euro (€/US$) is exactly the same as the spot rate Euro is “flat”
If the forward rate of the euro is above the spot rate Euro is at a “forward discount”
If the forward rate of the euro is below the spot rate Euro is at a “forward premium”
Hedging exchange rate exposure requires that firms have expectations or forecasts of future spot rates that they can compare to forward rates