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

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

3. The Real Exchange Rate We discussed exchange rates in Chapter 14 – Example: €1 = $1.50 Those exchange rates are nominal exchange rates Now we’ll discuss real exchange rates

4. 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, Europe’s 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

5. The Real Exchange Rate In general, the real exchange rate is a broad summary measure of the prices of one country’s goods and services relative to another’s. – The real dollar/euro exchange rate is the number of US reference commodity baskets—not 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

6. Depreciation and Appreciation EuroDollarEurope’s exportsAmerica’s exports q $/€ ↑Real Appreciation Real Depreciation More expensiveLess expensive q $/€ ↓Real Depreciation Real Appreciation Less expensiveMore expensive

7. 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.

8. 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 Europe’s borders relative to its purchasing power within the United States Or alternatively, a fall in the purchasing power of America’s products in general over Europe’s. Real appreciation of the dollar against the euro is the opposite of a real depreciation: a fall in q $/€. Real Depreciation and Appreciation

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

10. 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.

11. Absolute and Relative PPP

12. Prices and the Exchange Rate

13. Equation (16-2) of the textbook, KOM9e

14. The Interest Rate

15. Equation (16-5) of the textbook, KOM9e

16. The Interest Rate: Fisher Effect

17. Real Interest Rate Parity

18. The Interest Rate

19. 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 f ) Assumption: In the long run, the economy makes full use of all its resources Therefore, in long-run equilibrium, Y = Y f.

20. Output The full-employment output, Y f, is assumed to be exogenous Y = Y f is what we call a solution because it expresses an endogenous variable entirely in terms of exogenous variables

21. Inflation

24. The Interest Rate, again

25. The Price Level

26. Appreciation Rate of the Foreign Currency

27. The Exchange Rate

28. 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.

29. 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.

30. 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.

31. 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 level’s 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)

32. RELATIVE PURCHASING POWER PARITY: A LONG-RUN THEORY OF THE REAL EXCHANGE RATE We will return to this after discussing Chapter 17

33. Absolute PPP: logical, but not factual Despite the logical appeal of the Law of One Price or Absolute Purchasing Power Parity, available data suggests that it is not true This is why Relative Purchasing Power Parity is a more realistic alternative

34. Law of One Price for Hamburgers?

35. Equilibrium in the Goods Market

37. Real Exchange Rate in the Long Run It follows that: – Full-employment output (Y f ) has a direct effect on the real exchange rate (q) – Taxes (T) have a direct effect too – C 0 + I + G + CA 0 and CA q have inverse effects on the real exchange rate (q) When the supply of domestic goods increases, they will be cheaper relative to foreign goods. So, Y f ↑ causes q↑. When the demand for domestic goods increases, they will be more expensive relative to foreign goods, causing q↓.

38. Exercises How is the real exchange rate affected in the long run by a permanent increase in: – fiscal stimulus? – money supply? – foreigners’ preference for domestic products? – tariffs on imported goods? – foreign/domestic income and household wealth?

39. BONUS TOPIC: THE CURRENT ACCOUNT The balance on a country’s 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

40. The Current Account

41. CA Y f, T+ C 0, I, G−

42. The Current Account Contractionary fiscal policy or “fiscal austerity” (T↑ or G↓) is a way to raise a country’s net exports (CA↑) A fall in consumer wealth—caused by, say, a real estate crash or a stock market crash—reduces C 0 and therefore leads to an increase in CA! Monetary policy has no effect Tariffs on imports have no effect! CA Y f, T+ C 0, I, G−

43. The Long Run and Monetary Neutrality 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 slide are true for both the flexible exchange rate system of this chapter and the fixed exchange rate system of Chapter 18 CA Y f, T+ C 0, I, G−