Chapter 15 Price Levels and the Exchange Rate in the Long run
Chapter 15 ▪ Price Levels and the Exchange Rate in the Long Run
Chapter organization Introduction The law of one price Purchasing power parity A Long-Run Exchange Rate Model Based on PPP Empirical Evidence on PPP and the Law of One Price Explaining the Problems with PPP Copyright C 2003 Pearson Education, Inc Slide 15-2
Copyright © 2003 Pearson Education, Inc. Slide 15-2 ▪ Introduction ▪ The Law of One Price ▪ Purchasing Power Parity ▪ A Long-Run Exchange Rate Model Based on PPP ▪ Empirical Evidence on PPP and the Law of One Price ▪ Explaining the Problems with PPP Chapter Organization
Chapter organization Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates International Interest Rate Differences and the real Exchange Rate Real Interest parity Summary Appendix: The Fisher Effect, the Interest Rate, and the Exchange rate Under the Flexible-Price Monetary Ap pproach Copyright C 2003 Pearson Education, Inc Slide 15-3
Copyright © 2003 Pearson Education, Inc. Slide 15-3 ▪ Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates ▪ International Interest Rate Differences and the Real Exchange Rate ▪ Real Interest Parity ▪ Summary ▪ Appendix: The Fisher Effect, the Interest Rate, and the Exchange Rate Under the Flexible-Price Monetary Approach Chapter Organization
Introduction The model of long-run exchange rate behavior provides the framework that actors in asset markets use to forecast future exchange rates a Predictions about long-run movements in exchange rates are important even in the short run a In the long run, national price levels play a key role in determining both interest rates and the relative prices at which countries' products are traded The theory of purchasing power parity(PPP) explains movements in the exchange rate between two countries' currencies by changes in the countries' price evels Copyright C 2003 Pearson Education, Inc Slide 15-4
Copyright © 2003 Pearson Education, Inc. Slide 15-4 Introduction ▪ The model of long-run exchange rate behavior provides the framework that actors in asset markets use to forecast future exchange rates. ▪ Predictions about long-run movements in exchange rates are important even in the short run. ▪ In the long run, national price levels play a key role in determining both interest rates and the relative prices at which countries’ products are traded. • The theory of purchasing power parity (PPP) explains movements in the exchange rate between two countries’ currencies by changes in the countries’ price levels
The law of one price Law of one price Identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency This law applies only in competitive markets free of transport costs and official barriers to trade Example: If the dollar/pound exchange rate is $1.50 per pound a sweater that sells for $45 in New York must sell for 530 in London Copyright C 2003 Pearson Education, Inc Slide 15-5
Copyright © 2003 Pearson Education, Inc. Slide 15-5 The Law of One Price ▪ Law of one price • Identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency. – This law applies only in competitive markets free of transport costs and official barriers to trade. – Example: If the dollar/pound exchange rate is $1.50 per pound, a sweater that sells for $45 in New York must sell for £30 in London
The law of one price It implies that the dollar price of good i is the same wherever it is sold US=(Ese)X(pr where us Is the dollar price of good i when sold in the u.s E is the corresponding euro price in Europe s/e is the dollar/euro exchange rate Copyright C 2003 Pearson Education, Inc Slide 15-6
Copyright © 2003 Pearson Education, Inc. Slide 15-6 – It implies that the dollar price of good i is the same wherever it is sold: P i US = (E$/€) x (P i E ) where: P i US is the dollar price of good i when sold in the U.S. P i E is the corresponding euro price in Europe E$/€ is the dollar/euro exchange rate The Law of One Price
Purchasing Power Parity Theory of Purchasing Power Parity(PPP The exchange rate between two counties currencies equals the ratio of the counties' price levels It compares average prices across countries It predicts a dollar/euro exchange rate of E (15-1) where us Is the dollar price of a reference commodity basket sold in the United States Pe is the euro price of the same basket in Europe Copyright C 2003 Pearson Education, Inc Slide 15-7
Copyright © 2003 Pearson Education, Inc. Slide 15-7 Purchasing Power Parity ▪ Theory of Purchasing Power Parity (PPP) • The exchange rate between two counties’ currencies equals the ratio of the counties’ price levels. • It compares average prices across countries. • It predicts a dollar/euro exchange rate of: E$/€ = PUS/PE (15-1) where: PUS is the dollar price of a reference commodity basket sold in the United States PE is the euro price of the same basket in Europe
Purchasing Power Parity By rearranging Equation(15-1), one can obtain PUS =(ESeX (pe) S/e/X PPP asserts that all countries' price levels are equal when measured in terms of the same currency Copyright C 2003 Pearson Education, Inc Slide 15-8
Copyright © 2003 Pearson Education, Inc. Slide 15-8 Purchasing Power Parity ▪ By rearranging Equation (15-1), one can obtain: PUS = (E$/€) x (PE ) ▪ PPP asserts that all countries’ price levels are equal when measured in terms of the same currency
Purchasing Power Parity The relationship Between PPP and the Law of one Price The law of one price applies to individual commodities while PPp applies to the general price level If the law of one price holds true for every commodity PPP must hold automatically for the same reference baskets across countries Proponents of the PPP theory argue that its validity does not require the law of one price to hold exactly Copyright C 2003 Pearson Education, Inc Slide 15-9
Copyright © 2003 Pearson Education, Inc. Slide 15-9 ▪ The Relationship Between PPP and the Law of One Price • The law of one price applies to individual commodities, while PPP applies to the general price level. • If the law of one price holds true for every commodity, PPP must hold automatically for the same reference baskets across countries. • Proponents of the PPP theory argue that its validity does not require the law of one price to hold exactly. Purchasing Power Parity
Purchasing Power Parity Absolute ppp and relative ppp Absolute ppp It states that exchange rates equal relative price levels Relative ppp It states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels Relative ppp between the United States and Europe would be (EseEt-Es/et-l/Ese-1=TUSt-TE.t(15-2) where 兀,= inflation rate Copyright C 2003 Pearson Education, Inc Slide 15-10
Copyright © 2003 Pearson Education, Inc. Slide 15-10 ▪ Absolute PPP and Relative PPP • Absolute PPP – It states that exchange rates equal relative price levels. • Relative PPP – It states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels. – Relative PPP between the United States and Europe would be: (E$/€,t - E$/€, t –1 )/E$/€, t –1 = US, t - E, t (15-2) where: t = inflation rate Purchasing Power Parity