Microsoft PowerPoint – C16_ECON7520_week4
Chapter 16
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Price Levels and the Exchange Rate
in the Long Run
Instructor:
Learning Objectives
16.1 Explain the purchasing power parity theory of exchange
rates and the theory’s relationship to international goods-market
integration.
16.2 Describe how monetary factors such as ongoing price level
inflation affect exchange rates in the long run.
16.3 Discuss the concept of the real exchange rate.
16.4 Understand factors that affect real exchange rates and
relative currency prices in the long run.
16.5 Explain the relationship between international real interest
rate differences and expected changes in real exchange rates.
• Law of one price
• Purchasing power parity
• Long-run model of exchange rates: monetary approach
• Relationship between interest rates and inflation: Fisher
• Shortcomings of purchasing power parity
• Long-run model of exchange rates: real exchange rate
• Real interest rates
The Behavior of Exchange Rates (1 of 2)
• What models can predict how exchange rates behave?
– In last chapter we developed a short-run model and a
long-run model that used movements in the money supply.
– In this chapter, we develop two more models, building on
the long-run approach from last chapter.
– Long run means a sufficient amount of time for prices of all
goods and services to adjust to market conditions so that
their markets and the money market are in equilibrium.
– Because prices are allowed to change, they will influence
interest rates and exchange rates in the long-run models.
The Behavior of Exchange Rates (2 of 2)
• The long-run models are not intended to be completely
realistic descriptions about how exchange rates behave,
but ways of representing how market participants may
form expectations about future exchange rates and how
exchange rates tend to move over long periods.
Law of One Price (1 of 3)
• 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
those markets are not important.
– Why? Suppose the price of pizza at one restaurant is
$20, while the price of the same pizza at an identical
restaurant across the street is $40.
– What do you predict will happen? Many people will
buy the $20 pizza, few will buy the $40 one.
Law of One Price (2 of 3)
– Due to the price difference, entrepreneurs would have
an incentive to buy pizza at the cheap location and
sell it at the expensive location for an easy profit.
– Due to strong demand and decreased supply, the
price of the $20 pizza would tend to increase.
– Due to weak demand and increased supply, the price
of the $40 pizza would tend to decrease.
– People would have an incentive to adjust their
behavior and prices would tend to adjust until one
price is achieved across markets (across
restaurants).
Law of One Price (3 of 3)
• Consider a pizza restaurant in Seattle and one across the border in
Vancouver.
• The law of one price says that the price of the same pizza (using a common
currency to measure the price) in the two cities must be the same if markets
are competitive and transportation costs and barriers between markets are
not important.
US = priceof pizzainSeattle
Canada = priceof pizzainVancouver
US$/C$ = U.S.dollar / Canadiandollar exchangerateE
𝑃 = 𝐸 $/ $ × 𝑃
Purchasing Power Parity (1 of 3)
• 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
US = level of average prices in the U.S.P
Canada = level of average prices in CanadaP
US$/C$ = U.S.doller / Canadian doller exchange rateE
Purchasing Power Parity (2 of 3)
• Purchasing power parity (PPP) implies that the exchange rate is
determined by levels of average prices
– If the price level in the United States is US$200 per basket, while the
price level in Canada is C$400 per basket, PPP implies that
the C$/US$ exchange rate should be
C$400 / US$200 C$2 / US$1.
– Predicts that people in all countries have the same purchasing
power with their currencies: 2 Canadian dollars buy the same
amount of goods as 1 U.S. dollar, since prices in Canada are
twice as high.
Purchasing Power Parity (3 of 3)
• Purchasing power parity (PPP) comes in two forms:
• Absolute PPP: purchasing power parity that has already been discussed.
Exchange rates equal the level of relative average prices across countries.
• Relative PPP: changes in exchange rates equal changes in prices
(inflation) between two periods:
where inflation rate from perid 1 tot t t
Monetary Approach to Exchange Rates (1 of 5)
• Monetary approach to the exchange rate: uses monetary
factors to predict how exchange rates adjust in the long run,
based on the absolute version of PPP.
– It predicts that levels of average prices across countries
adjust so that the quantity of real monetary assets
supplied will equal the quantity of real monetary assets
Monetary Approach to Exchange Rates (2 of 5)
• To the degree that PPP holds and to the degree that
prices adjust to equate the quantity of real monetary
assets supplied with the quantity of real monetary assets
demanded, we have the following prediction:
– 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.
Monetary Approach to Exchange Rates (3 of 5)
Predictions about changes in
1. Money supply: a permanent rise in the domestic money supply
– causes a proportional increase in the domestic price level,
– thus causing a proportional depreciation in the domestic currency
(through PPP).
– This is same prediction as long-run model without PPP.
2. Interest rates: a rise in domestic interest rates
– lowers the demand of real monetary assets,
– and is associated with a rise in domestic prices,
– thus causing a proportional depreciation of the domestic currency
(through PPP).
Monetary Approach to Exchange Rates (4 of 5)
3. Output level: a rise in the domestic level of production and
income (output)
– raises domestic demand of real monetary assets,
– and is associated with a decreasing level of average
domestic prices (for a fixed quantity of money supplied),
– thus causing a proportional appreciation of the domestic
currency (through PPP).
• All three changes affect money supply or money demand,
and cause prices to adjust so that the quantity of real
monetary assets supplied matches the quantity of real
monetary assets demanded, and cause exchange rates to
adjust according to PPP.
Monetary Approach to Exchange Rates (5 of 5)
• A change in the money supply results in a change in the level
of average prices.
• A change in the growth rate of the money supply results in a
change in the growth rate of prices (inflation).
– A constant growth rate in the money supply results in a
persistent growth rate in prices (persistent inflation) at the
same constant rate, when other factors are constant.
– Inflation does not affect the productive capacity of the
economy and real income from production in the long run.
– Inflation, however, does affect nominal interest rates.
The Fisher Effect (1 of 2)
• The Fisher effect (named affect ) describes the
relationship between nominal interest rates and inflation.
– Derive the Fisher effect from the interest parity condition:
– If financial markets expect (relative) PPP to hold, then expected
exchange rate changes will equal expected inflation between
countries:
The Fisher Effect (2 of 2)
– Therefore,
e eR R
– The Fisher effect: a rise in the domestic inflation rate causes an
equal rise in the interest rate on deposits of domestic currency in
the long run, when other factors remain constant.
Monetary Approach to Exchange Rates (1 of 2)
• Suppose that the U.S. central bank unexpectedly increases
the growth rate of the money supply at time 0.t
• Suppose also that the inflation rate is in the United States
before 0 andt after this time, but that the European
inflation rate remains at 0%.
• According to the Fisher effect, the interest rate in the United States
will adjust to the higher inflation rate.
Figure 16.1 Long-Run Time Paths of U.S. Economic
Variables After a Permanent Increase in the Growth Rate of
the U.S. Money Supply
Monetary Approach to Exchange Rates (2 of 2)
• The increase in nominal interest rates decreases the demand of real monetary assets.
• In order for the money market to maintain equilibrium in the long run, prices must jump
• In order to maintain PPP, the exchange rate must jump (the dollar must depreciate) so
• Thereafter, the money supply and prices are predicted to grow at rate
and the domestic currency is predicted to depreciate at the same rate.
Shortcomings of PPP (1 of 5)
• There is little empirical support for absolute 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.
Figure 16.2 The Yen/Dollar Exchange Rate and
Relative Japan–U.S. Price Levels, 1980–2019
Relative PPP does not track the yen/dollar exchange rate 1980-2015.
Source: IMF, International Financial Statistics. Exchange rates and
price levels are end of the year data,.
Shortcomings of PPP (2 of 5)
Reasons why PPP may not be accurate: the law of one
price may not hold because of
1. Trade barriers and nontradable products
2. Imperfect competition
3. Differences in measures of average prices for baskets
of goods and services
Shortcomings of PPP (3 of 5)
• Trade barriers and nontradable products
– Transport costs and governmental trade restrictions
make trade expensive and in some cases create
nontradable 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.
Shortcomings of PPP (4 of 5)
• 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
– One price need not hold in two markets.
Shortcomings of PPP (5 of 5)
• Differences in the measure of average prices for
goods and services
– Levels 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.
– One price need not hold in two markets.
Law of One Price for Hamburgers?
Why Price Levels Are Lower in Poorer
Countries (1 of 3)
• When expressed in terms of a single currency, countries’
price levels are positively related to the level of real
income per capita.
– A dollar, when converted to local currency at the
market exchange rate, generally goes much further in
a poor country than in a rich one.
– Figure 16-3 illustrates the relation between price levels
and income, with each dot representing a different
• Non-tradables tend to be more expensive (relative to
tradables) in richer countries.
Why Price Levels Are Lower in Poorer
Countries (2 of 3)
• The Balassa-Samuelson theory assumes labor
productivity in poor countries is substantially lower than in
rich countries for tradables but not for non-tradables.
• If the prices of traded goods are roughly equal across
countries, the lower labor productivity in the tradables
industries of poor countries implies lower wages, lower
production costs in non-tradables, and thus lower prices of
non-tradables than rich countries.
• Productivity statistics support the Balassa-Samuelson
differential productivity explanation.
Why Price Levels Are Lower in Poorer
Countries (3 of 3)
• An alternative theory (by Bhagwati, Kravis, and Lipsey)
relies on differences in the endowments of capital and
labor, rather than productivity differences.
• The higher capital-labor ratios in rich countries compared
to poor countries makes the marginal productivity of labor
and hence the wage level higher in rich countries.
• Non-tradables are labor-intensive (use a higher ratio of
labor to capital) relative to tradables, making non-tradables
cheaper in poor, low-wage countries than they are in rich,
high-wage countries.
• Rich countries thus have higher overall price levels.
Figure 16.3 Price Levels and Real
Incomes, 2017
Consumer price levels tend to rise as their real income rises. Each dot
represents a country. The straight line represents a statistician’s best prediction
of a country’s price level relative to that of the United States based on its real
per capita income.
Source: Penn World Table, version 9.1.
The Real Exchange Rate Approach to
Exchange Rates (1 of 10)
• Because of the shortcomings of PPP, economists have tried to
generalize the monetary approach to PPP to make a better theory.
• The real exchange rate is the rate of exchange for goods and
services across countries.
– In other words, it is the relative value/price/cost of goods and
services across countries.
– For example, it is the dollar price of a European group of goods
and services relative to the dollar price of an American group of
goods and services:
$ / € EU
The Real Exchange Rate Approach to
Exchange Rates (2 of 10)
$ / € EU
– If the EU basket costs € 100, the U.S. basket costs $120, and the
nominal exchange rate is $1.20 per euro, then the real exchange rate is 1
U.S. basket per 1 EU basket.
– A real depreciation of the value of U.S. products means a fall in a
dollar′s purchasing power of EU products relative to a dollar′s
purchasing power of U.S. products.
▪ This implies that U.S. goods become less expensive and less
valuable relative to EU goods.
▪ This implies that the value of U.S. goods relative to value of EU
goods falls.
The Real Exchange Rate Approach to
Exchange Rates (3 of 10)
$ / € EU
– A real appreciation of the value of U.S. products
means a rise in a dollar’s purchasing power of EU
products relative to a dollar’s purchasing power of
U.S. products.
▪ This implies that U.S. goods become more
expensive and more valuable relative to EU goods.
▪ This implies that the value of U.S. goods relative to
value of EU goods rises.
The Real Exchange Rate Approach to
Exchange Rates (4 of 10)
• According to PPP, exchange rates are determined by relative
average prices:
• According to the more general real exchange rate approach,
exchange rates may also be influenced by the real exchange rate:
• What influences the real exchange rate?
The Real Exchange Rate Approach to
Exchange Rates (5 of 10)
• A change in relative demand of U.S. products
– An increase in relative demand of U.S. products causes the value
(price) of U.S. goods relative to the value (price) of foreign goods to rise.
– A real appreciation of the value of U.S. goods: USP rises relative to
$ / € EUE P
– The real appreciation of the value of U.S. goods makes U.S. exports
more expensive and imports into the U.S. less expensive (thereby
reducing the relative quantity demanded of U.S. products).
– A decrease in relative demand of U.S. products causes a real
depreciation of the value of U.S. goods.
The Real Exchange Rate Approach to
Exchange Rates (6 of 10)
• A change in relative supply of U.S. products
– An increase in relative supply of U.S. products (caused by an increase
in U.S. productivity) causes the price/cost of U.S. goods relative to the
price/cost of foreign goods to fall.
– A real depreciation of the value of U.S. goods: USP falls relative to
$ / € EUE P
– The real depreciation of the value of U.S. goods makes U.S. exports
less expensive and imports into the United States more expensive
(thereby increasing relative quantity demanded to match increased
relative quantity supplied).
– A decrease in relative supply of U.S. products causes a real
appreciation of the value of U.S. goods.
Figure 16.4 Determination of the Long-
Run Real Exchange Rate
The long-run equilibrium real exchange rate equates world relative demand to
the full-employment level of relative supply.
The Real Exchange Rate Approach to
Exchange Rates (7 of 10)
• The real exchange rate is a more general approach to explain
exchange rates. Both monetary factors and real factors influence
nominal exchange rates:
1a. Increases in monetary levels lead to temporary inflation and
changes in expectations about inflation.
1b. Increases in monetary growth rates lead to persistent inflation
and changes in expectations about inflation.
2a. Increases in relative demand of domestic products lead to a
real appreciation.
2b. Increases in relative supply of domestic products lead to a real
depreciation.
The Real Exchange Rate Approach to
Exchange Rates (8 of 10)
• What are the effects on the nominal exchange rate?
• When only monetary factors change and PPP holds, we have the
same predictions as before.
– No changes in the real exchange rate occurs.
• When factors influencing real output change, the real exchange rate
– With an increase in relative demand of domestic products, the
real exchange rate adjusts to determine nominal exchange rates.
– With an increase in relative supply of domestic products, the
situation is more complex.
The Real Exchange Rate Approach to
Exchange Rates (9 of 10)
• With an increase in the relative supply of domestic products, the real
exchange rate adjusts to make the price/cost of domestic goods depreciate,
but the relative amount of domestic output also increases.
– This second effect increases the demand of real monetary assets in the
domestic economy:
– Thus 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:
The Real Exchange Rate Approach to
Exchange Rates (10 of 10)
• When economic changes are influenced only by
monetary factors, and when the assumptions of PPP
hold, nominal exchange rates are determined by PPP.
• When economic changes are caused by factors that
affect real output, exchange rates are not determined by
PPP only, but are also influenced by the real exchange
Interest Rate Differences
• A more general equation of differences in nominal interest rates across countries can
be derived from
US/EU US/EU $ / € $ / € US EU
US/EU $ / €
$ / € $ / €
US/EU US/EU$ € US EU
• The difference in nominal interest rates across two countries is now the sum of
– the expected rate of depreciation in th
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