2016/11/2 Commodity price and Exchange Rates Purchasing Power Parity Law of one price Absolute ppp does not hold If the identical product or service can be sold in Transportation costs, which depend on geography and different markets, and no restrictions exist on the sale or chnology nsportation costs of moving the product between Tariffs non-tariff trade barriers arkets arbitrage would soon equalize the products price Other border frictions in the markets Purchasing Power Parity ue for all goods and services, the purchasing er parity (ppp) exchange rate could be found from any individual set of prices. A simple conversion from US dollar price ps to RMB price But it tells how much international goods market is integrate P gives PsxS=P" and where competitiveness of multinational firms lie at. The PPP Exchange Rate The Real Exchange Rate PPP exchange rate is the rate implied by the commodity prices Implication for a country's export It gives an estimate of what rate would make the same basket A made-in-China product, priced in RMB as Y300, given of goods and services cost the same in two different countrie the nominal x/s rate 0. 15, the s price should be $45. If rising labor costs in China lead Y price rising to 350, at is about 4.5 Price of Chinese goods to Americans rises by 16.67%]loss While the nominal rate is 6.6 of competitiveness in the global product market Therefore, RMB is undervalued according to its purchasing real terms, the us dollar has fallen in value(depreciated) power. lative to RMB; or, RMB appreciates against uS dollar in screpancy The Real Exchange Rate PPP and Currency Under- or Over-Valuation 3 options to gain back the competitivene Another perspective of PPp ncies often need to be evaluated 2. keep s price unchanged, accept thinner profit margin gainst other currency values to determine relativ 3. Use the nominal rate as a weapo preciation of RMB from 0.15 to 0.1286 offsets the 50×0.1286=545 The objective is to discover whether ons exchang Real exchange rate rate is " overvalued or*undervalued"in terms of Ppp RER=S"P*/PS: let s suppose US-made products sell at S50 Before depreciation: RER=S'P/Ps =0. 15300/50=0.9 Examples: BigMac Index, Starbucks Index, GDP After depreciation: RER=S*P/P5=0.1286*350/50=0.9 adjusted Big Mac Index2016/11/2 5 Commodity Prices and Exchange Rates • Law of One Price – If the identical product or service can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the product between markets, arbitrage would soon equalize the products price in the markets. • Purchasing Power Parity – If LOP were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. – A simple conversion from US dollar price P$ to RMB price P¥ gives P$ x S = P¥ 4-25 Purchasing Power Parity • Absolute PPP does not hold well because there are barriers – Transportation costs, which depend on geography and technology – Tariffs & non-tariff trade barriers – Other border frictions • But it tells how much international goods market is integrated and where competitiveness of multinational firms lie at. 4-26 The PPP Exchange Rate • PPP exchange rate is the rate implied by the commodity prices in the two countries. • It gives an estimate of what rate would make the same basket of goods and services cost the same in two different countries. • Example – the IMF’s current estimate of the PPP exchange rate for RMB is about 4.5 – While the nominal rate is 6.6 – Therefore, RMB is undervalued according to its purchasing power. – Implication: Firms or individuals should in general sell products in $ and buy in ¥ (don’t forget the discrepancy among products!) 4-27 The Real Exchange Rate • Implication for a country’s exporting – A made-in-China product, priced in RMB as ¥300, given the nominal ¥/$ rate 0.15, the $ price should be $45. – If rising labor costs in China lead ¥ price rising to 350, at the unchanged nominal rate, the $ price is $52.50. – Price of Chinese goods to Americans rises by 16.67%loss of competitiveness in the global product market! – In real terms, the US dollar has fallen in value (depreciated) relative to RMB; or, RMB appreciates against US dollar in real terms. 4-28 The Real Exchange Rate • 3 options to gain back the competitiveness: 1. cut cost: and how? 2. keep $ price unchanged accept thinner profit margin 3. Use the nominal rate as a weapon: An depreciation of RMB from 0.15 to 0.1286 offsets the effect. (350×0.1286= $45.) • Real exchange rate • RER=S*P¥ /P$ ; let’s suppose US-made products sell at $50 • Before depreciation: RER=S*P¥ /P$ =0.15*300/50=0.9 • After depreciation: RER=S*P¥ /P$ =0.1286*350/50=0.9 4-29 PPP and Currency Under- or Over-Valuation • Another perspective of PPP – Individual national currencies often need to be evaluated against other currency values to determine relative purchasing power. – The objective is to discover whether a nation’s exchange rate is “overvalued” or “undervalued” in terms of PPP. • Examples: BigMac Index, Starbucks Index, GDPadjusted BigMac Index 4-30