1. 14 1 Exchange Rates and Prices in the Long Run 2 Money, Prices, and Exchange Rates in the Long Run 3 The Monetary Approach 4 Money, Interest, and Prices in the Long Run 5 Monetary Regimes and Exchange Rate Regimes 6 Conclusions EXCHANGE RATES and Purchasing Power Parity (PPP) (Chap. 14, section 1; plus pp. 525-527; 529)

2. 2 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Motivation On July 26, 2008, the price of 1 big Mac is 280 Japanese Yen in Japan, 2.29 pounds in U.K., 3.37 Euros in Euro zone, and about $3 in the U.S. Should these price levels tell us something about spot exchange rates?

3. 3 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor LEARNING OBJECTIVES 1. Exchange Rates and Prices in the Long Run Understand long-run arbitrage in goods market Understand law of one price (LOOP) and purchasing power parity (PPP) Understand real exchange rates  Real exchange rate and relationship to PPP  Real appreciations and real depreciations  Overvaluations and undervaluations Understand PPP as it relates to both price levels P and rates of change of prices (inflation,  ) Understand how and why PPP works in the long run but not in the short run

4. 4 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Introduction to Exchange Rates and Prices Consider the prices and exchange rates in the U.S. and Canada:  Prices of a representative basket of goods (CPI basket) in U.S. and Canada  1970P CAN = C$1001990P CAN =C$392  1970P US =$1001990P US =$336  Exchange rates (C$/$)  1970E C$/$ =11990 E C$/$ =1.16  Prices of baskets in common currency (U.S. $)  Canada1990$338 (= C$392/1.16) Is it coincidence that the exchange rate and price level adjusted in this way?

5. 5 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Introduction to Exchange Rates and Prices Arbitrage  Chapter 13: applied to the foreign exchange market  Chapter 14: applied to the goods market The prices of goods and services in different countries is related to the exchange rate. When the relative prices of goods changes, the exchange rate adjusts to reflect this change. The monetary approach to exchange rates is a long run theory linking money, exchange rates, prices, and interest rates.

6. 6 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor The Law of One Price Key assumption – frictionless trade  No transaction costs  No barriers to trade  Identical goods in each location  No barriers to price adjustment General idea:  Prices must be equal in all locations for any good when expressed in a common currency.  Otherwise, there would be a profit opportunity from buying low and selling high.

7. 7 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor The Law of One Price Consider a single good, g, in 2 different markets. The law of one price (LOOP) states that the price of the good in each market must be the same. This is a microeconomic concept, applied to a single good, g. http://www.x-rates.com/ Relative price ratio for g:

8. 8 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor The Law of One Price If LOOP holds then: This means the price of good g is the same in Europe and in the U.S. What if LOOP doesn’t hold?  Goods less expensive in U.S.  Goods less expensive in Europe

9. 9 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Purchasing Power Parity Macroeconomic counterpart to LOOP.  If LOOP holds for every good in CPI basket, then the prices of the entire baskets must be the same in each locations. The purchasing power parity (PPP) theory states that these overall price levels in each market must be the same. Relative price level ratio:

10. 10 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor The Real Exchange Rate The relative price level ratio q is an important concept. It is called the real exchange rate The real exchange rate has some terminology in common with the nominal exchange rate.  Nominal exchange rate E is the ratio at which currencies trade,  Real exchange rate q is ratio at which goods baskets trade.

11. 11 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor The Real Exchange Rate Changes in the real exchange rate:  If the real exchange rate rises  more home goods are needed in exchange for foreign goods  real depreciation.  If the real exchange rate falls  fewer home goods are needed in exchange for foreign goods  real appreciation.

12. 12 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Exercise 1 If price increases in the U.S., other things equal, there is a real depreciation for U.S. $. T/F? A: False. As P US rises, U.S. goods become more expensive. This corresponds to a real appreciation.

13. 13 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Exercise 2 If the price decreases in Europe, other things equal, there is a real appreciation for U.S. $. T/F? A: True. As P E decreases, European goods become cheaper. This is a real depreciation for Euros and a real appreciation for $.

14. 14 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Exercise 3 If there is a nominal appreciation for $, other things equal, there is also a real appreciation for $. T/F? A: True. A nominal appreciation means that 1 $ is worth more Euros. Since 1 U.S. good is worth the same number of $ (same for European good), U.S. goods become more expensive. This is a real appreciation.

15. 15 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Purchasing Power Parity If PPP (Absolute PPP) holds then: This implies that a basket of goods purchased in two countries should cost the same in a common currency Alternatively, under absolute PPP Absolute PPP says that the real exchange rate = 1; or that the spot exchange rate equals the relative price.

16. 16 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Absolute PPP and the Real Exchange Rate What if absolute PPP does not hold?  If the real exchange rate is above one (by x %)  foreign (European) goods are relatively expensive  foreign currency (the euro) is overvalued (by x %).  If the real exchange rate is below one (by x %)  foreign (European) goods are relatively cheap  foreign currency (the euro) is undervalued (by x %t).

17. 17 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Absolute PPP: Evidence

18. 18 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Absolute PPP: Evidence

19. 19 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Absolute PPP: Evidence

20. 20 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Evidence on Absolute PPP According to absolute PPP, relative prices should be equal to spot exchange rate. They are not equal, but move in the same direction

21. 21 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Relative PPP, Inflation, and Exchange Rate Depreciation Assumption: Δ =0  The rate of change in the exchange rate is the rate of depreciation in the home currency (U.S. $):

22. 22 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Relative PPP, Inflation, and Exchange Rate Depreciation The rate of change in prices can be found by substituting in the absolute PPP condition into the expression above. This is the home-foreign inflation differential:

23. 23 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Relative PPP, Inflation, and Exchange Rate Depreciation Relative PPP: This is another way to forecast the exchange rate Relative PPP implies that the rate of depreciation of the nominal exchange rate equals the inflation differential.

24. 24 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Relative PPP, Inflation, and Exchange Rate Depreciation Relative PPP is derived from Absolute PPP  If Absolute PPP holds (i.e. q E/US = 1) then Relative PPP (i.e. Δq E/US = 0) must hold also.  But the converse need not be true: one could imagine a case where a basket always costs a fixed amount more, say, 10% in common currency terms in one country than the other—Absolute PPP fails, but Relative PPP holds.

25. 25 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Relative PPP, Inflation, and Exchange Rate Depreciation The PPP theory, whether in absolute of relative form, suggests that price levels in different countries and exchange rates are tightly linked, either in levels or in rates of change.  Where do price levels come from?  Do the data support the theory of purchasing power parity?

26. 26 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Evidence on Relative PPP: Long Run According to relative PPP, the percentage change in the exchange rate should equal the inflation differential.

27. 27 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Zimbabwe Hyperinflation Factiva Search: Zimbabwe Central Banker Answers to Mugabe, Bible

28. 28 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Zimbabwe Hyperinflation Background  Inflation = 100,580% in Jan., 2008 and 8,000,000% in June 2008. (source: WSJ)  Starting in Nov. 2008, the monthly inflation rate is 13.2 billion percent (i.e. price doubles every 15.6 hours) (source: wikipedia.org)  Factories operating at 30% of capacity or less  Unemployment at 80% The government's role  Wage and price controls have created shortages.  In addition, real income has decreased as the government seized white-owned farms, disrupting production.

29. 29 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Hyperinflation: Other Countries Yugoslav dinar of 1993. Daily inflation rates of 100% in 1993. Jan. 1994, 1 DM = 6 trillion dinars. See also http://www.rogershermansociety.org/yugoslavia3.htm http://www.rogershermansociety.org/yugoslavia3.htm

30. 30 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Hyperinflation: Other Countries Hungary pengo of 1946. Denomination: 100 million B-pengo = 10 26 pengos

31. 31 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Currency Reform Death of currencies  Cases where countries have been or become “dollarized”  Often a result of hyperinflation (in some developing countries)  Unilateral adoption of foreign currency  No influence over monetary policy

32. 32 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Evidence for Relative PPP: Hyperinflations Hyperinflation occurs when the monthly inflation rate equals 50% or more over a sustained period.  Relative PPP predicts the high inflation differentials should lead to sharp depreciation in the currency.

33. 33 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor What Explains Deviations from PPP? Transaction costs  Recent estimates suggest transportation costs may add about 20% to the cost of goods moving internationally.  Tariffs (and other policy barriers) may add another 10%, with variation across goods and across countries.  Further costs arise due to the time taken to ship goods. Nontraded goods  Some goods are inherently nontradable;  Most goods fall somewhere in between freely tradable and purely nontradable.  For example: a cup of coffee in a café. It includes some highly-traded components (coffee beans, sugar) and some nontraded components (the labor input of the barista).

34. 34 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor What Explains Deviations from PPP? Imperfect competition and legal obstacles  Many goods are differentiated products, often with brand names, copyrights, and legal protection.  Firms can engage in price discrimination across countries, using legal protection to prevent arbitrage  E.g., if you try to import large quantities of a pharmaceuticals, and resell them, you may hear from the firm’s lawyers. Price stickiness  One of the most common assumptions of macroeconomics is that prices are “sticky” prices in the short run.  PPP assumes that arbitrage can force prices to adjust, but adjustment will be slowed down by price stickiness.

35. HEADLINES 35 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor The Big Mac Index For over 20 years The Economist newspaper has used PPP to evaluate whether currencies are undervalued or overvalued.  Recall, home currency is x% overvalued/undervalued when the home basket costs x% more/less than the foreign basket.  It is really a LOOP-based test because it relies on a single good. The Economist uses a very simple “basket” consisting of just one globally uniform, standardized product: The Big Mac

36. HEADLINES 36 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor The Big Mac Index Invented in 1986 by economics editor Pam Woodall. Ask correspondents around the world to visit McDonalds and get prices, then computes the price in each location relative to the U.S.:  The % deviation (+/–) from the U.S. price measures the over/under valuation of the local currency based on the burger basket.  Updated every year: http://www.economist.com/markets/Bigmac/ http://www.economist.com/markets/Bigmac/

37. HEADLINES 37 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor The Big Mac Index In 2004 The Economist tried using a new globally uniform, standardized product. Starbucks tall latte

38. HEADLINES 38 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor The Big Mac Index

39. 39 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Summary: PPP as a Theory of Exchange Rate In levels - Absolute PPP: In rates of change: Relative PPP

40. 40 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Chapter Outline 1.Exchange Rates and Prices in the Long Run: Purchasing Power Parity and Goods Market Equilibrium  Goods Market Equilibrium  The Law of One Price (LOOP)  Purchasing Power Parity (PPP)  The Real Exchange Rate  Implications of PPP  Absolute PPP and the Real Exchange Rate  Absolute PPP, Prices, and the Nominal Exchange Rate  Relative PPP, Inflation, and Exchange Rate Depreciation  Empirical Evidence on PPP  How Slow is Convergence to PPP?  What Explains Deviations from PPP?

41. 41 of 98 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Key Points 1.Purchasing power parity implies that the exchange rate should equal the relative price level in the two countries, and the real exchange rate should equal 1. 2.Evidence for PPP is weak in the short run, but more favorable in the long run.  In the short run, deviations are common and changes in the real exchange rate do occur.  The failure of PPP in the short run is primarily the result of price stickiness and market frictions and imperfections that limit arbitrage.