Presentation on theme: "Preview: 9/29, 10/1 Quiz: Yfe … P … E"— Presentation transcript:
1 Preview: 9/29, 10/1 Quiz: Yfe … P … E Moments to remember: Instant/Short-run/Long-runThe Long-Run: Put on Your Monetarist HatLaw of one price/Purchasing power parity in theoryMonetary approach to exchange rateFisher effect … another parity conditionPPP in practiceDeviations from PPPBalassa-Samuelson / Bhagwati-Kravis-LipseyReal exchange rate approachReal interest rate parity
3 Law of One Price / Purchasing Power Parity The law of one price: the price of the same stuff in competitive markets measured in the same currency must be the sameAssume no transportation costs or other barriers to trade.PbourbonUS = E$/€ x PcognacEurope$/Bottle = ($/ €)x (€ /Bottle) = $/BottlePurchasing power parity applies the law of one price across countries for all goods and services… really for representative groups (“baskets” or “bottles”) of goods and services.PUS = (E $/€ ) x (PEurope)Purchasing power parity implies thatE $/€ = PUS/ PeuropeLevels of average prices determine the exchange rate.People in all countries have the same purchasing power with their currencies: if US prices in dollars are twice as high as European prices in euros, $2 exchange for €1.
4 Δ E$/€,t = (E$/€,t - E$/€, t –1)/E$/€, t –1 = US, t - EU, t Purchasing power parity comes in 2 flavors:Absolute PPP:E$/€ = PUS/PEURelative PPP: changes in exchange rates equal changes in prices (inflation) between two periods:Δ E$/€,t = (E$/€,t - E$/€, t –1)/E$/€, t –1 = US, t - EU, twhere t = inflation rate from period t-1 to tA country’s currency depreciates to the extent that its inflation rate exceeds the inflation rate abroad.
5 Shortcomings of PPP: The Yen/Dollar Exchange Rate and Relative Japan-U Shortcomings of PPP: The Yen/Dollar Exchange Rate and Relative Japan-U.S. Price Levels, 1980–2006Source: IMF, International Financial Statistics. Exchange rates and price levels are end-of-year data.
6 But we’ll treat PPP as valid in the long-run PPP and the law of one price may not hold because ofTrade barriers and non-tradable productsTransport 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 (for example, haircuts).The greater the transport costs, the greater the range over which the exchange rate can deviate from its PPP value.Imperfect competition price discrimination: “pricing to market.”Differences in the measure of average prices for goods and serviceslevels of average prices differ across countries because of differences in how representative groups (“baskets”) of goods and services are measured.Because measures of groups of goods and services are different, the measure of their average prices need not be the same.But we’ll treat PPP as valid in the long-run
9 Price Levels and Real Incomes, 2004 Source: Penn World Table, Mark 6.2.
10 Monetary Approach to Exchange Rates: A long –run view Monetary approach to the exchange rate: use absolute PPP :In each country, prices adjust in the long-run soMsUS/PUS = L (R$, YUS)MsEU/PEU = L (R€, YEU)Monetary factors predict how exchange rates adjust in the long-run.PUS = MsUS/L (R$, YUS)PEU = MsEU/L (R€, YEU)andE $/€ = PUS/ PEU = [MsUS/L (R$, YUS)]/[MsEU/L (R€, YEU)]The exchange rate is determined in the long run by prices, which are determined by the relative supply and demand of real monetary assets in money markets across countries.
11 But what causes R to rise permanently (in the long-run)? Monetary approach predictions about exchange rate changes:Money supply: a permanent rise in Mscauses a proportional increase in the domestic price levelcausing a proportional depreciation in the domestic currency (through PPP).… just as before (Chapter 14)2. Output level (Y) : a rise in the long-run level of domestic production and incomeraises domestic demand of real monetary assetsdecreases long-run level of average domestic prices for Ms fixedcausing a proportional appreciation of the domestic currency (through PPP)… just as before (Quiz #3).3. Interest rates (R): a rise in domestic interest rateslowers the demand of real monetary assetsincreases the long-run level of average domestic prices for Ms fixedcausing a proportional depreciation of the domestic currency (through PPP)not like before (Chapter 14)!But what causes R to rise permanently (in the long-run)?
12 The Fisher Effect: Inflation and Interest Rates The Fisher effect (named for Irving Fisher) describes the relationship between nominal interest rates and inflation.The international Fisher effect derived from interest parity and relative PPP:R$ - R€ = (Ee$/€ - E$/€)/E$/€ = eUS - eEUA rise in the domestic inflation rate an equal rise in the domestic interest rate in the long-run, ceteris paribusWhat causes inflation to increase?A change in the Ms growth rate in a change in the growth rate of prices (inflation, ).A constant Ms growth rate persistent price inflation () at the same constant rate, ceteris paribus.Inflation does not affect productive capacity and real income in the long-run.Inflation does affect the nominal interest rate via the Fisher effect.
13 Long-Run Time Paths of U. S Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money Supply: Assume flexible Price Level, P
14 Long-Run Time Paths of U. S Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money SupplyImmediate increase in expected inflation an immediate increase in the nominal interest rate an immediate decrease in the demand for real monetary assets.For the money market to maintain equilibrium, the price level must jump up sincePUS = MsUS/L(R$, YUS)Ms does not increase immediately but L(R$, YUS) declines immediately.In order to maintain PPP, the exchange rate must jump immediately (the dollar must depreciate) soE$/€ = PUS/PEUThereafter, the money supply and prices grow at rate π + π and the domestic currency depreciates at the same rate, as was expected.
15 How a Rise in U.S. Monetary Growth Affects Dollar Interest Rates and the Dollar/Euro Exchange Rate When Goods Prices Are Flexible: The Movie
16 The Role of Inflation and Expectations Long run results from the model of Chapter 14changes in money supply lead to changes in the level of average prices.no inflation is predict to occur in the long run, but only during the transition to the long run equilibrium.During the transition, inflation causes the nominal interest rate to increase to its long run value.Expectations of higher domestic price and currency depreciation cause the expected return on foreign currency deposits to increase, making the domestic currency depreciate before the transition period.the level of average prices does not immediately adjust even if expectations of inflation adjust the exchange rate overshootsLong run results from the monetary approach (with PPP),the rate of inflation increases permanently when the growth rate of the money supply increases permanently.With persistent domestic inflation (above foreign inflation), the monetary approach also predicts an increase in the domestic nominal interest rate.Expectations of higher domestic inflation cause the expected purchasing power of domestic currency to decrease relative to the expected purchasing power of foreign currency, thereby making the domestic currency depreciate.The level of average prices adjusts with expectations of inflation, causing the domestic currency to depreciate, but with no overshooting.
17 The Real Exchange Rate Approach to Exchange Rates The real exchange rate: the rate of exchange for goods and services across countries.qUS/EU = (E$/€ x PEU)/PUSqUS/EU = ( $/€ )x (€/cognac) / ($/bourbon) = (bourbon/cognac)Real depreciation of the value of U.S. products qUS/EU risesthe dollar’s purchasing power of EU products relative to the dollar’s purchasing power of U.S. products falls … gotta give more Bourbon per CognacThe real exchange rate and the nominal rate: elaborating PPPE$/€ = qUS/EU x PUS/PEUWhat changes qUS/EU?An increase in relative demand for US products real appreciation of “$”An increase in relative supply of U.S. products real depreciation of “$”
18 The Long-Run Real Exchange Rate Upward slope of RD: the more Bourbon Europeans get per Cognac, the more US stuff they demand relative to their own stuff.When the relativesupply of US stuff matches the relative demand for US stuff, there is no tendency for the price of US Bourbon relative to the price of EU Cognac to change.In the long run, the supplyof goods and services ineach country depends onfactors of production likelabor, capital andtechnology—not prices orexchange rates.Suppose the supply of long run output in the US economy is equal to Y1US and the supply of long run output in the EU is equal to Y1EU. In the long run, these two quantities depend on the productive capacity of the respective economy--on factors of production like labor, physical capital, technology, natural resources, and so on. They do not depend on the real exchange rate. That is, they do not depend on the nominal exchange rate, nor the price levels in either economy. Thus, the relative supply of US products, (YUS/YEU)1, is also independent of the real exchange rate. We represent this independence by drawing a vertical line in the graph.
19 The Real Exchange Rate Approach to Exchange Rates A more general approach to explain exchange rates.Both monetary and real factors influence nominal exchange rates:1a. increases in monetary levels temporary inflation and changes in expectations about the price level and exchange rate.1b. increases in monetary growth rates persistent inflation and changes in expectations about the rates of inflation and exchange rate depreciation.2a. increases in relative demand for domestic products a real appreciation.2b. increases in relative supply of domestic products a real depreciation.Effects of changes in real exchange rates on nominal exchange ratesE$/€ = qUS/EU x PUS/PEUWhen only monetary factors change and PPP holds, we have the same predictions as before: no changes in the real exchange rate occursWhen factors influencing real output change, the real exchange rate changes.
20 E$/€ = qUS/EU x PUS/PEU PUS = MsUS/L (R$, YUS) Effects of changes in real exchange rates on nominal exchange ratesE$/€ = qUS/EU x PUS/PEUWhen only monetary factors change and PPP holds, we have the same predictions as before: no changes in the real exchange rate occursWhen factors influencing real output change, the real exchange rate changes.An increase in relative demand for domestic products real exchange rate appreciates as does the nominal exchange rate.An increase in relative supply of domestic products: a more complex situationAn increase in the relative supply of domestic products qUS/EU depreciatesBut the relative amount of domestic output increases, increasing Ld.PUS = MsUS/L (R$, YUS)The level of average domestic prices is predicted to decrease relative to the level of average foreign prices.The effect on the nominal exchange rate is ambiguous:?
21 Interest Rate Differences: Nominal and Real A more general equation of differences in nominal interest rates across countries can be derived from:qeUS/EU = Ee$/€ x PeUS/PeEU(qeUS/EU - qUS/EU)/qUS/EU = [(Ee$/€ - E$/€)/E$/€] – (eUS - eEU)From Interest Rate Parity: R$ - R€ = (Ee$/€ - E$/€)/E$/€R$ - R€ = (qeUS/EU - qUS/EU)/qUS/EU + (eUS - eEU)The difference in nominal interest rates across two countries is now the sum of:The expected rate of depreciation in the value of domestic goods relative to foreign goods (real depreciation)PlusThe difference in expected inflation rates between the domestic economy and the foreign economy
22 Interest Rate Differences: Nominal and Real Real interest rate = re = Inflation-adjusted interest rate:re = R – πeReal interest rates are measured in terms of real output:the quantity of goods and services savers can buy when their assets pay interestthe quantity of goods and services borrowers cannot buy when they must pay interestReal interest rate differentials between countries are derived fromreUS – reEU = (R$ - eUS) - (R € - eEU)Our previous result: R$ - R€ = (qeUS/EU - qUS/EU)/qUS/EU + (eUS - eEU)So: reUS – reEU = (qeUS/EU - qUS/EU)/qUS/EUThe last equation is called real interest parity.Differences in real interest rates between countries (in terms of goods and services that are earned when lending) equal the expected change in the value/price/cost of goods and services between countries.A country must offer high real interest rates when its real exchange rate is expected to depreciate.