Price Levels and the Exchange Rate in the Long Run

1. Price Levels and the ExchangeRate in the Long Run

2. CHAPTER ORGANIZATION • Introduction • The Law of One Price • Purchasing Power Parity • The Real Exchange Rate • Summary

3. INTRODUCTION • Changes in income, the price level, interest rates, and the money supply all affect the exchange rate in the short run • What are the determinants of the exchange rate in the long run? • Changes in the money supply impacts on a country’s inflation rate which will affect interest rates and prices and, therefore, the exchange rate • A benchmark exchange rate can be defined, but the current exchange rate often differs

4. THE LAW OF ONE PRICE • The Law of One Price • Disregarding barriers to trade and transportation costs, the law of one price states that identical goods sold in competitive markets should cost the same everywhere when prices are expressed in terms of the same currency • The convergence of prices over time is called arbitrage • The law of one price states comparative advantage in terms of currencies

5. THE LAW OF ONE PRICE • However, prices for identical goods are not equal even in large country—and much less so in all international markets • The appropriate way to think about the law is that there is a tendency for prices of identical goods to equalize between countries • Because of transport costs, barriers to trade, and differences in tax rates and regulations, goods rarely sell for exactly the same price in international market

6. THE LAW OF ONE PRICE • Over time the price differential should narrow • The relationship between two prices and the exchange rate can be expressed as PUS = [R($/£)]  PUK • Or [R($/£)] = PUS/PUK

7. THE LAW OF ONE PRICE Table 16.1 Purchasing Power Parity and the Big Mac (partial) Cash and carry The hamburger standard, July 2007

8. PURCHASING POWER PARITY • Purchasing Power Parity • For law of one price to hold, the goods discussed must be tradable between countries • Individuals must be able to move goods from the low-priced country to a high priced country • Purchasing power parity (PPP) is the theory that changes in exchange rates are related to changes in relative prices among countries • Purchasing power parity extends the concept of the law of one price to the price of a representative market basket of goods

9. PURCHASING POWER PARITY • Purchasing power parity states that an exchange rate between two countries should equal the ratio of the price level in those countries • Purchasing power parity should be thought of as a tendency or as a long-run concept • It is possible for a country’s current exchange rate to vary significantly from the value predicted by purchasing power parity as other determinants change

10. PURCHASING POWER PARITY • Large deviations from purchasing power parity become important • As exchange rates fluctuate over time, purchasing power parity can be used as a benchmark that allows one to determine where the exchange rate should be based on a country’s relative price level versus where the current exchange rate actually is • In the long run, an exchange rate will tend to move toward this benchmark

11. PURCHASING POWER PARITY • To claim a country’s currency is over-valued or under-valued or weak or strong, there must be some benchmark from which to judge • Generally that benchmark is based on purchasing power parity • Actual exchange rates are rarely exactly at purchasing power parity • The exchange rate can be measured against purchasing power parity to determine if it is “high” or “low”

12. PURCHASING POWER PARITY • Absolute Purchasing Power Parity • Absolute purchasing power parity is the theory that the bilateral exchange rate between two countries is related to the ratio of the level of prices between two countries • The dollar/pound exchange rate predicted by the absolute purchasing power parity is expressed as [R($/£)] = PUS/PUK

13. PURCHASING POWER PARITY • Rearranging the previous equation PUS = [R($/£)]  PUK • Prices in the U.S. would be equal to the pound price of the market basket of tradable goods • The exchange rate may change in nominal terms, in in real terms the amount of goods you can buy has not changed • If the exchange rate does not exactly match the price level ratio, the difference will have an important implication for a country’s trade flows

14. PURCHASING POWER PARITY • Relative Purchasing Power Parity • Relative purchasing power parity states that the percentage change in the bilateral exchange rate is equal to the difference in the percentage change in price levels over any given time period • Relative purchasing power parity is a statement about price and exchange rate changes over time

15. PURCHASING POWER PARITY • Price changes are normally reported as percentage changes on an annual basis • This can be shown formally as %∆XR = %∆PUS – %∆PUK • Absolute purchasing power parity assumes the market basket of tradable goods to be identical in both countries • This requires market baskets have identical weights of identical goods

16. PURCHASING POWER PARITY • As each country’s market basket is different than other country’s baskets, each country’s price index is slightly different from every other country’s index • These differences limit the usefulness of absolute purchasing power parity • Comparisons are still valid as long as the factors that cause the price levels to change in each country are similar

17. PURCHASING POWER PARITY • Purchasing Power Parity in the Short Run and the Long Run • Relative prices and exchange rates move together in long run • In the short run, exchange rates can deviate significantly from purchasing power parity, and the difference can be dramatic • Purchasing power parity is most useful as a long-run benchmark for what the exchange rate should be as it is a poor predictor of the actual exchange rate

18. 3.50 – 3.00 – 2.50 – 2.00 – 1.50 – 1.00 – 1966 69 72 75 78 81 84 87 90 93 96 99 2002 2005 Exchange Rate U.S./U.K. Price Levels PURCHASING POWER PARITY Table 16.2 The Dollar/Pound Exchange Rate and Relative U.S./U.K. Price Levels, 1966–2006

19. PURCHASING POWER PARITY • The relative PPP may be a better tool for examining changes in exchange rate • In the short run the actual exchange rate deviates substantially from that predicted by the relative PPP • The deviations are less severe than with absolute PPP, so it seems to work “better”

20. 20.00 – 15.00 – 10.00 – 5.00 – 0.00 – –5.00 – –10.00 – –15.00 – –20.00 – 1966 69 72 75 78 81 84 87 90 93 96 99 2002 2005 %∆ in the Exchange Rate % U.S. Prices – % U.K. Prices PURCHASING POWER PARITY Table 16.3 Percentage Change in the Exchange Rate and the Percentage Difference in Relative Prices, 1966–2006

21. PURCHASING POWER PARITY • Both versions of PPP fail as reliable predictors of short-run changes in the exchange rate • In the long run, however, both series tend to move together • Unfortunately, the exchange rate has a tendency to “overshoot” the target • Empirical research over the last several decades supports the conclusion that PPP works much better in the long run than the short run • Neither approach works well in the short run

22. PURCHASING POWER PARITY • There are a number of explanations why PPP fails many empirical tests • There is a question of which market basket to use • In practice, there are three price indexes that could be used, consumer price index (CPI), the GDP price deflator, and the Producer Price Index (PPI) • The consensus is that using the PPI is the best choice as CPI and the GDP deflator contain nontradable goods making them less desirable

23. PURCHASING POWER PARITY • Price indexes are computed differently between countries • There are variations in the content of market baskets between countries • There are variations in the weights assigned to goods in market baskets • While conceptually simple, comparing prices between two countries is fraught with difficulties

24. PURCHASING POWER PARITY • Barriers or market conditions may allow prices to diverge between countries • Transportation costs are not, in fact, zero • The higher the transportation costs, the more likely the prices are to diverge • Even in a free market, products could have widely different prices in two countries and the differences could persist indefinitely

25. PURCHASING POWER PARITY • Differences in market structures between countries could cause the prices of the same product to vary • Products sold in competitive markets vary in price from products sold in imperfectly competitive markets • Comparing products in smaller versus larger countries or cities within the U.S. will show differences due to differences in the level of competition

26. PURCHASING POWER PARITY • Government policies also cause international differences in price • Tariffs and other barriers to entry cause price distortions between countries • Taxes also affect a product’s price as different countries use different methods of taxation. • Other taxes and industrial policy can also lead to different product prices between countries

27. PURCHASING POWER PARITY • Existence of nontradable goods is also a problem in testing PPP • Generally nontradable goods are goods in which the transportation costs are so high relative to the value of the product that international trade does not occur • Collectively these account for about 60% of the GDP in the U.S. • The problem is that prices are determined wholly by the domestic market

28. PURCHASING POWER PARITY • Virtually all price indexes contain a certain percentage of nontradable goods • Further, prices of nontradable goods are implicitly included in the prices of traded goods • Prices between countries may differ because the price is “contaminated” by nontradable production costs • It becomes almost impossible to compare international prices for “purely” tradable goods

29. PURCHASING POWER PARITY • Poor data is only part of the failure of PPP • A good portion of the problem is the discussion of short run versus long run • We know in the long run, PPP works reasonably well • The consensus is that it should take between three and five years for the deviation of exchange rate and PPP to reconcile

30. PURCHASING POWER PARITY • Nominal Exchange Rates in the Long Run • Many currencies have long run trends in their nominal exchange rate • Usually these are the result of some underlying factor in the economy • PPP indicates changes in the nominal exchange rate are a function of changes in the relative prices between countries • We need to link a country’s price level to the money supply

31. PURCHASING POWER PARITY • Equilibrium in a country’s money supply occurs when the money supply is equal to the demand for money MD = k(P)(Y) • Using separate money demand functions for the U.S. and the U.K. MSUS = kUS(Nominal GDPUS) = kUS(PUS)  (YUS) MSUK = kUK(Nominal GDPUK) = kUK(PUS)  (YUK)

32. PURCHASING POWER PARITY • Different factors determine the variables associated in these equilibrium relationships • These factors include central bank actions, public preferences, growth rate of the labor force, growth rate of the productivity of labor, and improvements in technology • If we take the ration of these two equations and rearrange the terms, we have (PUS/PUK) = (MSUS/MSUK)  (kUK/kUS)  (YUK/YUS)

33. PURCHASING POWER PARITY • Using the relationship between PPP and the nominal exchange rate, the nominal exchange rate becomes [R($/£)] = (MSUS/MSUK)  (kUK/kUS)  (YUK/YUS) • Nominal exchange rate is a function of relative prices between two countries • Relative prices between two countries are a functions of the relative money supplies, the public’s willingness to hold money, and the real GDP’s in each country

34. PURCHASING POWER PARITY • Consider the effect of a change in prices on the nominal exchange rate • If prices in U.S. are rising relative to prices in U.K., then nominal exchange rate would also increase • For this to have happened, one of the underlying determinants (changes in money supplies, desire to hold money, or real GDP’s) must have changed • We can explain differences in relative prices caused by differences in the money supply’s growth rate

35. PURCHASING POWER PARITY • A change in the public’s preference for holding money can also cause the relative prices level to change • A change in the ratio of real GDP’s between countries can cause a change in the ratio of prices between countries • Putting all this together, we can make some general statements concerning the factors that change a nominal exchange rate in the long run

36. PURCHASING POWER PARITY • A rising relative price level causes the exchange rate to change in a predicable manner, to depreciate • Changes in money supply can change the price ratio and thus cause the nominal exchange rate to change • Changes in the relative demands for money and relative rates of growth in real GDP can also affect the price ratio and, thus, the nominal exchange rate in the long run

37. THE REAL EXCHANGE RATE • Another important exchange rate is the real exchange rate • To determine the real exchange rate we need to determine the real price of goods in the marketplace • Nominal prices can be deceiving as nominal changes may or may not be changes in real terms • Markets, including the exchange rate market, react to changes in real prices or exchange rates

38. THE REAL EXCHANGE RATE • The nominal or posted exchange rate is the relative price of two currencies • The real exchange rate (RXR) is the relative price of two currencies after adjusting for changes in domestic prices within the two countries • The real exchange rate is [RXR($/£)] = [R($/£)][PUK/PUS]

39. THE REAL EXCHANGE RATE • Nominal exchange rates are observable in the foreign exchange market on a daily basis • Real exchange rates are not directly observable • A change in the nominal may or may not also mean a change in the real exchange rate • A change in the nominal exchange rate may just offset inflation differentials resulting in no change in the real exchange rate • It may also reflect a change in the real exchange and it can be difficult to know if the change is “real”

40. 4.00 – 3.50 – 3.00 – 2.50 – 2.00 – 1.50 – 1.00 – 1966 69 72 75 78 81 84 87 90 93 96 99 2002 2005 Exchange Rate Real Exchange Rate THE REAL EXCHANGE RATE Table 16.4 The Dollar/Pound Exchange Rate and The Real Dollar/Pound Exchange Rate, 1966–2006

41. THE REAL EXCHANGE RATE • Without an understanding of the real exchange rate, one is likely to mistake every nominal exchange rate change for a real exchange rate change • This may lead one to incorrectly conclude that changes in nominal rates would mean foreign goods are necessarily cheaper in real terms • Considering only nominal rates and not real exchange rates may result in poor business decisions

42. 150 – 140 – 130 – 120 – 110 – 100 – 90 – 80 – 70 – 60 – 1990 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 05 06 Real Exchange Rate Nominal Exchange Rate THE REAL EXCHANGE RATE Table 16.5 China’s Nominal and Real Effective Exchange Rate, 1997–2006

43. THE REAL EXCHANGE RATE • Changes in the Real Exchange Rate • We can now describe why the real exchange rate may change in the ling run [RXR($/£)] = [R($/£)][PUK/PUS] • There are three major factors that would cause the real exchange rate to change in the long run

44. THE REAL EXCHANGE RATE • The first factors is foreign (world) demand for domestically produced products and domestic demand for foreign produced products • Increased demand by the U.K. for U.S. goods would cause prices in U.S. rise relative to prices in U.K. • The dollar would appreciate in real terms to offset the increase in prices • A net real increase in demand for foreign goods will cause real appreciation of the foreign currency

45. THE REAL EXCHANGE RATE • Changes in a country’s productivity will also cause a change in the real exchange rate • Long-run labor and capital productivity increases may lead to excess supply of goods produced domestically • This excess supply causes the exchange rate to rise and a real depreciation of the domestic currency • These difference may be relatively small but they exist nonetheless

46. THE REAL EXCHANGE RATE • Generally changes in real demand and real supply are subtle and occur over long periods of time • But real exchange rates can change substantially in the short run • Most of the short-run changes in the real exchange rate are related to interest rate changes • Changes in interest rates can have effects on the real exchange rate as well as the nominal exchange rate

47. THE REAL EXCHANGE RATE • The real interest rate is the nominal interest rate minus the expected rate of inflation • To examine this it is necessary to look at the flow of portfolio capital between countries • The real interest rate parity condition is the proposition that changes in the real exchange rate are related to changes in real interest rates

48. THE REAL EXCHANGE RATE • The nominal interest rates between the U.S. and the U.K. may be defined as iUS = rUS + %∆PUS iUK = rUK + %∆PUK • Suppose the real interest rate in the U.S. increases relative to the real interest rate in the U.K. • Capital would flow from the U.K. to the U.S. in search of a higher rate of return

49. THE REAL EXCHANGE RATE • If a country’s expected real interest rate changes, the real exchange rate must also change • Empirically, real interest parity is analogous to purchasing power parity • Empirical tests usually confirm that much of the time real interest parity does not hold • It should be viewed as a tendency — increases in real interest rates will have a tendency to cause real exchange rates to appreciate

50. THE REAL EXCHANGE RATE • Perfect real interest parity does not always hold, but it would be odd for a real exchange rate to depreciate in the face of rising interest rates • In most countries, the central bank can influence nominal interest rates through changes in the money supply • In many cases this translates into changes in the real exchange rate • This provides a mechanism by which monetary policy can affect the real exchange rate and the balance of payments