MGEC61 Chapter 16: Price Levels and Exchange Rates in the Long Run Summary

Real appreciation

A real appreciation of the dollar against the euro is a fall in q$/€. This fall indicates a decrease in the relative price of products purchased in Europe, or a rise in the dollar's European purchasing power compared with that in the United States.18

Absolute PPP

- Form of PPP stated in LEVELS OF PRICES and LEVELS OF EXCHANGE RATE - Tells us that in absence of frictions such as transportation, costs, tariffs, others; should cost same amount of money to purchase identical basket of goods in different countries when expressed in same currency. Absolute PPP: E = P/P*

Relative PPP

- Form of PPP stated in terms of inflation rates and exchange rates - RPPP tells that percentage in exchange rate between two currencies over any period equals to inflation rate differentials between two countries. - [(E^e-E)/E] = π - π* - Implication: RPPP tells us that rate of country's currency depreciates by excess of its inflation over that of another country

Purchasing power parity

- the idea that exchange rates are determined by the amount of different currencies required to purchase a representative bundle of goods. Explains movements in the exchange rate between two currencies by changes in the countries' price levels - When PPP holds, individual will be indifferent in buying an identical good at home or abroad because it will cost the same amount of money in different countries when measured in the same currency

What is the building block of the PPP theory? What does this theory state? What do proponents of the PPP theory often argue?

A building block of the PPP theory is the law of one price, which states that under free competition and in the absence of trade impediments, a good must sell for a single price regardless of where in the world it is sold. Proponents of the PPP theory often argue, however, that its validity does not require the law of one price to hold for every commodity.

Monetary approach to the exchange rate

A model of exchange rate determination which shows factors that affect money supply and money demand will play a role in determining the exchange rate. 3 assumptions: 1) PPP holds continuously E=P/P* 2) Stable money demand function L(R,Y) 3) Money market always in equilibrium, and prices fully flexible P=MS/L(R,Y) and *

Real depreciation

A rise in the real dollar/euro exchange rate q$/€, (which we call a real depreciation of the dollar against the euro) can be thought of in several equivalent ways. Most obviously, (16-6) shows this change to be a fall in the purchasing power of a dollar within Europe's borders relative to its purchasing power within the United States. This change in relative purchasing power occurs because the dollar prices of European goods (E$/€ * PE) rise relative to those of U.S. goods (PUS).

Real exchange rate

Real exchange rate (q) measures the purchasing power of a country's currency relative to another country's currency. Real exchange rate, q, shows how many baskets of domestic goods are needed to exchange one basket of foreign goods. q increases, DC depreciates in real terms q decreases, DC appreciates in real terms Factors which affect q: 1) Changes in relative demand for domestic products 2) Changes in relative supply of domestic products

Real interest rate

Clearly the price of future consumption in terms of present consumption has something to do with the interest rate. As we will see in the second half of this book, in the real world the interpretation of interest rates is complicated by the possibility of changes in the over- all price level. For now, we bypass that problem by supposing that loan contracts are specified in "real" terms: When a country borrows, it gets the right to purchase some quantity of consumption at present in return for repayment of some larger quantity in the future. Specifically, the quantity of repayment in the future will be (1+r) times the quantity borrowed in the present, where r is the real interest rate on borrowing. Since the trade-off is one unit of consumption in the present for (1+ r) units in the future, the relative price of future consumption is 1/(1 + r).

All else equal, a country's currency undergoes long-run real appreciation against the world relative demand for its output _____________. In this case, country's real exchange rate, _________. Home currency undergoes long-run real _____________ against foreign currencies when home output ________ relative to foreign output. The real exchange rate ________

Deviations from relative PPP can be viewed as changes in a country's real exchange rate, the price of a typical foreign expenditure basket in terms of the typical domestic expenditure basket. All else equal, a country's currency undergoes a long-run real appreciation against foreign currencies when the world relative demand for its output rises. In this case, the country's real exchange rate, as just defined, falls. The home cur- rency undergoes a long-run real depreciation against foreign currencies when home output expands relative to foreign output. In this case, the real exchange rate rises.

What factors are used to explain the failures of PPP and law of one price?

The empirical support for PPP and the law of one price is weak in recent data. The failure of these propositions in the real world is related to trade barriers and departures from free competition, factors that can result in pricing to market by exporters. In addition, different definitions of price levels in different countries bedevil attempts to test PPP using the price indices governments publish. For some products, including many services, international transport costs are so steep that these products become nontradable.

Fisher effect

The equation tells us that all else equal, a rise in a country's expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer. Similarly, a fall in the expected inflation rate will eventually cause a fall in the interest rate. The Fisher effect is behind the seemingly paradoxical monetary approach prediction that a currency depreciates in the foreign exchange market when its interest rate rises relative to foreign currency interest rates.

Nominal interest rate

The expected real interest rate, denoted r^e, is defined as the nominal interest rate, R, less the expected inflation rate, r^e = R - π^e

What do the interest parity condition equate?

The interest parity condition equates international differences in nominal interest rates to the expected percentage change in the nominal exchange rate. If interest parity holds in this sense, a real interest parity condition equates international differences in expected real interest rates to the expected change in the real exchange rate. Real interest parity also implies that international differences in nominal interest rates equal the difference in expected inflation plus the expected percentage change in the real exchange rate.

Law of one price

The law of one price states that in competitive markets free of transportation costs and official barriers to trade (such as tariffs), identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency. For example, if the dollar/pound exchange rate is $1.50 per pound, a sweater that sells for $45 in New York must sell for £30 in London. The dollar price of the sweater when sold in London is then ($1.50 per pound) × (£30 per sweater) = $45 per sweater, the same as its price in New York.

What two theories combined determine nominal exchange rates in the long run? A stepwise increase in country's money stock ultimately leads to proportional increase in __________ and proportional fall in currency's _________ _________ _________.

The long-run determination of nominal exchange rates can be analyzed by combining two theories: the theory of the long-run real exchange rate and the theory of how domestic monetary factors determine long-run price levels. A stepwise increase in a country's money stock ultimately leads to a proportional increase in its price level and a proportional fall in its currency's foreign exchange value, just as relative PPP pre- dicts. Changes in monetary growth rates also have long-run effects consistent with PPP. Supply or demand changes in output markets, however, result in exchange rate movements that do not conform to PPP.

What does the monetary approach to exchange rate use to explain? In what terms? What is this theory? The monetary approach finds that a rise in country's interest rate will be associated with __________ of its currency.

The monetary approach to the exchange rate uses PPP to explain long-term exchange rate behavior exclusively in terms of money supply and demand. In that theory, long- run international interest differentials result from different national rates of ongoing inflation, as the Fisher effect predicts. Sustained international differences in monetary growth rates are, in turn, behind different long-term rates of continuing inflation. The monetary approach thus finds that a rise in a country's interest rate will be associated with a depreciation of its currency. Relative PPP implies that international interest differences, which equal the expected percentage change in the exchange rate, also equal the international expected inflation gap.

What does the purchasing power parity theory in its absolute form assert? What is the difference between absolute PPP and relative PPP?

The purchasing power parity theory, in its absolute form, asserts that the exchange rate between countries' currencies equals the ratio of their price levels, as measured by the money prices of a reference commodity basket. An equivalent statement of PPP is that the purchasing power of any currency is the same in any country. Absolute PPP implies a second version of the PPP theory, relative PPP, which predicts that percent- age changes in exchange rates equal differences in national inflation rates.

Pricing to market

When a firm sells the same product for different prices in different markets, we say that it is practicing pricing to market. Pricing to market may reflect different demand conditions in different countries. For example, countries where demand is more price-inelastic will tend to be charged higher markups over a monopolistic seller's production cost. Empirical studies of firm-level export data have yielded strong evidence of pervasive pricing to market in manufacturing trade.

Nominal exchange rate

When we wish to differentiate a real exchange rate—which is the relative price of two output baskets—from a relative price of two currencies, we will refer to the latter as a nominal exchange rate. But when there is no risk of confusion, we will continue to use the shorter term, exchange rate, to refer to nominal exchange rates