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Price Levels and the Exchange Rate in the Long Run Chapter 16 International Economics Udayan Roy

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Overview Long-run analysis – Real variables – Nominal variables Flexible exchange rates – We will study fixed exchange rates in Chapter 18

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The Real Exchange Rate We discussed exchange rates in Chapter 14 – Example: 1 = $1.50 Those exchange rates are nominal exchange rates Now well discuss real exchange rates

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The Real Exchange Rate Let us consider the price of an iPhone in US and Europe: – In US, it is P US = $200 – In Europe, it is P E = 150 – The value of the euro is E = 2 dollars per euro – So, Europes price in dollars is E × P E = $300 – So, each iPhone in Europe costs as much as 1.5 iPhones in US – E × P E / P US = 1.5 – This is the real dollar/euro Exchange Rate for iPhones

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The Real Exchange Rate In general, the real exchange rate is a broad summary measure of the prices of one countrys goods and services relative to anothers. – The real dollar/euro exchange rate is the number of US reference commodity basketsnot just iPhones that one European reference commodity basket is worth – Equation (16-6) in KOM9e E $/ is the nominal exchange rate, the price of one euro in dollars P E is the overall price level in Europe, such as the consumer price index P US is the overall price level in the United States

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Depreciation and Appreciation EuroDollarEuropes exportsAmericas exports q $/ Real Appreciation Real Depreciation More expensiveLess expensive q $/ Real Depreciation Real Appreciation Less expensiveMore expensive

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The Real Exchange Rate Example: If the European reference commodity basket costs 100, the U.S. basket costs $120, and the nominal exchange rate is $1.20 per euro, then the real dollar/euro exchange rate (q $/ ) is 1 U.S. basket per European basket.

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Real depreciation of the dollar against the euro – A rise in the real dollar/euro exchange rate (q $/) is a fall in the purchasing power of a dollar within Europes borders relative to its purchasing power within the United States Or alternatively, a fall in the purchasing power of Americas products in general over Europes. Real appreciation of the dollar against the euro is the opposite of a real depreciation: a fall in q $/. Real Depreciation and Appreciation

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Absolute PPP A very simple theory of the real exchange rate is called Absolute Purchasing Power Parity It says that: q = 1 Why?

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Law of One Price Going back for a second to the iPhone example, one can argue that P US, the dollar price in the US, ought to be equal to E × P E, the dollar price in Europe. That is,iPhone example E × P E = P US. In general, E $/ x P E = P US. Therefore, q $/ = (E $/ x P E )/P US = 1. This is the Law of One Price or Absolute Purchasing Power Parity.

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Absolute and Relative PPP Chapter 16 of the textbook (KOM9e) uses Absolute PPP in the first part of the chapter and Relative PPP in the second part – Absolute PPP: q = 1 – Relative PPP: q = a constant, not necessarily 1 Although the results in the following slides have been proved for APPP, they are also true under RPPP

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Prices and the Exchange Rate

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Equation (16-2) of the textbook, KOM9e

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The Interest Rate

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Equation (16-5) of the textbook, KOM9e

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The Interest Rate: Fisher Effect

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The Interest Rate

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Output The real GNP produced when all resources are fully utilized is known by various names: – Long-run GNP – Natural GNP – Full-employment GNP – Potential GNP(Y p ) Assumption: In the long run, the economy makes full use of all its resources Therefore, in long-run equilibrium, Y = Y p.

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Inflation

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The Interest Rate, again

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The Price Level

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Appreciation Rate of the Foreign Currency

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The Exchange Rate: APPP version

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Summary: Long-Run, Flexible Exchange Rates The crucial point to note about these expressions is that the variables on the right-hand sides of these equations are all exogenous. As exogenous variables are mystery variables about which our theory has nothing to say, the equations on this slide say all that our theory can say about the endogenous variables on the left-hand sides of these equations.

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Summary: Long-Run, Flexible Exchange Rates Keep in mind that we are talking about the long run here. So, these equations show us the long run effects of permanent changes in the exogenous variables on the equations right-hand sides.

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Summary: Long-Run, Flexible Exchange Rates The first two variables are real variables: they can be measured even in barter (or, non-monetary) economies. The remaining variables are nominal variables: they make sense only on monetary economies. Note that the money supply (M s ) has no effect on real variables. This is an instance of monetary neutrality in the long run.

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Summary: Long-Run, Flexible Exchange Rates Flashback to Ch. 15 of the textbook (KOM9e): A change in the supply of money has no effect on the long-run values of the interest rate or real output. (p. 369) A permanent increase in the money supply causes a proportional increase in the price levels long-run value. In particular, if the economy is initially at full employment, a permanent increase in the money supply eventually will be followed by a proportional increase in the price level. (p. 370)

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Absolute PPP: logical but not factual Despite the logical appeal of Absolute Purchasing Power Parity, available data suggests that it is not true We need to look for another theory of the real exchange rate, q.

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Law of One Price for Hamburgers?

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BONUS TOPIC: THE CURRENT ACCOUNT The balance on a countrys current account (CA) is roughly its net exports What does CA depend on in the long run? We will return to this after discussing Chapter 17

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The Current Account

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YCA YpYp ++ T0+ I, G0

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The Long Run The macroeconomic analysis of the long run is characterized by the concept of monetary neutrality That is, monetary arrangements and monetary policy have no effect on the behavior of real variables Therefore, the predictions summarized by the table on this and the previous slide are true for both the flexible exchange rate system of this chapter and the fixed exchange rate system of Chapter 18 YCA YpYp ++ T0+ I, G0

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