Copyright © 2006 Pearson Addison-Wesley. All rights reserved Chapter 15 Price Levels and the Exchange Rate in the Long Run

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Preview Two Approaches to the Determination of FOREX Rate or E 1) Purchasing Power Parity Theory: ‘Monetary Approach’ or ‘Monetarist Approach” 2) Real Exchange Rate Analysis : Real Factor Analysis Both are Long -un models of exchange rates

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Purchasing Power Parity: 1) Fundamental Force Assuming that there is an equilibrating force built into the world market economy, which will set the equilibrium FOREX rates in such a way that a fixed amount of a currency (say, Canadian $) may buy the same amount of goods anywhere in the world after the currency conversion.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved ) The ‘new PPP’ comes from the old ‘Law of One Price for One Good’ The law of one price simply says that the same good in different competitive markets must sell for the same price when transportation costs and barriers between markets are not important.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved ) Formally, Purchasing Power Parity Purchasing power parity is the application of the law of one price across countries for all goods and services, or for representative groups (“baskets”) of goods and services. (E Canada$/us$ ) P US = (P Canada ) P US = price level of goods and services in the US P Canada = price level of goods and services in Canada E Canada$/us$ = exchange rate

Copyright © 2006 Pearson Addison-Wesley. All rights reserved PPP implies that E Canada$/us$ = P Canada / P US  The price levels adjust to determine the exchange rate.  If the price level in the US is US$200 per basket, while the price level in Canada is C$300 per basket, PPP implies that the C$ /US$ exchange rate should be C$300/US$200 = C$ 1.5 / US$ 1 = E c$/us$.  Purchasing power parity says that each country ’ s currency has the same purchasing power: 1.5 Canadian dollars buy the same amount of goods and services as does 1 US dollar, since prices in Canada are 50% as high.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved ) Two Versions of Purchasing Power Parity Purchasing power parity comes in 2 forms: Absolute PPP: purchasing power parity that has already been discussed. Exchange rates equal price levels across countries. E $/€ = P $ /P EU Relative PPP: changes in exchange rates equal changes in prices (inflation rates)  %E $/€, =  $ -  EU, where  t = inflation rate

Copyright © 2006 Pearson Addison-Wesley. All rights reserved ) Purchasing Power Parity assumes E $/€ = P $ /P EU E $/€ / (P $ /P EU )=1 at all times *Question: If the PPP holds in reality, what would be the graphs of the relative price data, Money supplies of two countries and the FOREX rate like?

Copyright © 2006 Pearson Addison-Wesley. All rights reserved ) PPP is also called ‘Monetary Approach’ Holds in Long-run.  In particular, FOREX rate is determined by the relative price level, which is proportional to relative money supply of the two countries.  Assuming no changes in real factors such as demand or supply of goods; the only change is due to money suppies and the price levels.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Monetary Approach to Exchange Rates (cont.) The exchange rate is determined in the long run by relative prices (P/P), which are determined by the relative supply of money across countries across countries.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved A Simple Math Express is: 1) A bsolute PPP: E $/€ = P $ /P EU = 2) Relative PPP:  %E $/€, =  $ -  EU =  %MS $ -  %MS EU

Copyright © 2006 Pearson Addison-Wesley. All rights reserved * Monetary Approach to Exchange Rates: Combine PPP and the Long-run Money- Price Relationship a permanent rise in the domestic money supply  causes a proportional increase in the domestic price level in the long-run;  causing a proportional depreciation in the domestic currency (through PPP).

Copyright © 2006 Pearson Addison-Wesley. All rights reserved * Expectations and Depreciation feed back to the Short-run Model through the FOREX Market. If the above is repeated, now people form expectations, linking money creation to depreciation immediately. People develop an Expected Rise in FOREX Rate. Now going back to the Short-run Interest Parity Model(Chapter 13): In the Financial Market, Expectations of Depreciation of Domestic Currency cause the Expected Return on Foreign Investment to increase, acutally making the domestic currency depreciate immediately.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved ) Shortcomings of PPP There is little empirical support for purchasing power parity.  The prices of identical commodity baskets, when converted to a single currency, differ substantially across countries. Relative PPP is more consistent with data, but it also performs poorly to predict exchange rates.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Shortcomings of PPP (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Shortcomings of PPP (cont.) Reasons why PPP may not be a good theory: 1.Trade barriers and non-tradable goods and services 2.Imperfect competition 3.Differences in price level measures

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Shortcomings of PPP (cont.) Trade barriers and non-tradables  Transport costs and governmental trade restrictions make trade expensive and in some cases create non-tradable goods or services.  Services are often not tradable: services are generally offered within a limited geographic region (e.g., haircuts).  The greater the transport costs, the greater the range over which the exchange rate can deviate from its PPP value.  One price need not hold in two markets.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Shortcomings of PPP (cont.) Imperfect competition may result in price discrimination: “pricing to market”.  A firm sells the same product for different prices in different markets to maximize profits, based on expectations about what consumers are willing to pay. Differences in price level measures  price levels differ across countries because of the way representative groups (“baskets”) of goods and services are measured.  Because measures of goods and services are different, the measure of their prices need not be the same.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved The Real Exchange Rate Approach to Exchange Rates 1)Introducing Real Factors According to PPP, exchange rates are determined by relative price ratios: E $/ € = P $ /P € According to the more general real exchange rate approach, exchange rates may also be influenced by the real exchange rate: E $/ € = q $/ € x P $ /P €, and q is not constant at 1.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved ) Simple Definition of Real Exchange Rate By definition, on surface, q $/EU = (E $/€ x P EU )/P $ This is the simple definition of real exchange rate. This is the real domestic currency price of foreign currency. When this falls, there is a real depreciation of FOREX, and a real appreciation of domestic currency.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved ) Changes in q: What do we call? Example) Real Deprecation of FOREX or Real Appreciation of Domestic Currency q $/EU = (E $/€ x P EU )/P $  If the EU basket costs €100, the Canadian basket costs $120 and the nominal exchange rate is $1.20 per euro, then the real exchange rate is 1.  If the EU basket costs €100, the Canadian basket costs $120 and the nominal exchange rate is $1.00 per euro, then the real exchange rate is  When q goes down, we say that there is a real depreciation of FOREX or a real appreciation of domestic currency: We say that the international competitiveness of domestic good increases.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Real Exchange Rate Analysis of FOREX Rate:  Note that E and q go move together in this case.  E is determined by q, and q is determined by Real Factors.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved ) Complex Function of Real Exchange Rate What influences the real exchange rate? Relative Sizes of International Demand and Domestic Supply that affect Supply of and Demand for FOREX in the country q = f( International Excess Demand(-); Increased Domestic Supply to the World(-)) = f (Net Exports(-)) = f (Net Demand for Domestic Goods) =f (Net Supply of FOREX) =f(Current Account Surplus)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved * Japan in the 1970s and 80s. International Demand Japanese Supply – Technical Innovation Current Account Surplus E q