Price Levels & the Exchange Price Levels & the Exchange Rate in the Long RunRate in the Long Run

• Demand shifts in markets for goods and services→have sustained effects on exchange rates.

• In the long run, national price levels play a key role in determining ①interest rateinterest rate

the relative prices at which countries’ ②products are traded.

Purchasing Power Parity (PPP)Purchasing Power Parity (PPP)1. PPP explains exchange movements by

changes in countries’ price levels

2. PPP failed to give accurate long-run predictions

3. PPP can be modified to account for supply and demand shifts in countries’ output markets

4. Relationship of PPP, money, output market, interest rate

The Law of One PriceThe Law of One Price

• Is it different from absolute PPP?

Purchasing Power ParityPurchasing Power Parity

• PPP: the exchange rate between two countries’ currencies equals the ratio of the countries’ price levels.

• Chinese version:

The relationship between PPP & the law of one price

• The law of one price applies to individualindividual commodities, while PPP applies to the generalgeneral price level, which is a composite of the prices of all the commodities that enter into the reference basket.

Absolute PPP & Relative PPPAbsolute PPP & Relative PPP

• Development of the equations:• Relative PPP:→changesRelative PPP:→changes• Absolute PPP:→levelsAbsolute PPP:→levels

RequirementsRequirements

• Absolute PPP: international standardized basket of commodities

• Relative PPP: inflationary differences (differ in coverage and composition)

• Relative PPP: approximate percentage changes

a long-run exchange rate model based on PPP

• the monetary approach to the exchange rate• how exchange rates and monetary factors

interact in the long run• long run→does not allow for the price

rigidities• the monetary approach proceeds as if prices

can adjust right away to maintain full employment as well as PPP.

Fundamental equation of the monetary approach

),(

),( $/$

EE

sE

US

sUS

E

USE

YRLM

YRLM

P

PE

Money supplyMoney supply

Money demandMoney demand

3 variables: money supply interest rate output level① ② ③3 variables: money supply interest rate output level① ② ③

ConclusionConclusion

• The exchange rate, which is the relative price of (Country A & B) money, is fully determined in the long run by the relative supplies of those monies and the relative real demand for them.

eE

eUSE

eE

eUS

E

EeE

ee

RR

E

EE

P

pp

$

/$

/$/$

Interest Rate Parity still hold

The Fisher Effect

1. a rise in a country’s expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer.

2. purely monetary developments should have no effect on an economy’s relative prices

Paradoxical monetary approach prediction

• a currency depreciates when its interest rate↑?

• expected home inflation rises relative to foreign

• domestic price stickiness in the short run

money supplymoney supply①①

interest interest riserise

②②国外变量国外变量不动不动

Reduce money demand

Price level jumps to Price level jumps to reduce Mreduce Mss

③③④④

exchange rate jumpsexchange rate jumps

Empirical evidence on PPP & the Empirical evidence on PPP & the Law of one priceLaw of one price

• (P.408)

1. transport costs

2. government regulations

3. product differentiation.

4. McDonald’s some power to tailor prices to the local market (wages of service people…)

Explaining the problems with PPPExplaining the problems with PPP

1. transportation costs + trade barrier

2. monopolistic/oligopolistic practices

3. inflation data + commodity baskets

①Trade barriers & nontradables

• the cost of producing some goods and services that they can never be traded internationally at a profit.

• haircut, routine medical treatment, aerobic dance instruction, housing

• services and the output of the construction industry

②Departures from free competition

• when a single firm sells a commodity for different prices in different markets.

③International differences in price level measurement

• Norwegian consumes more reindeer…

• Japanese consumes more sushi…

• Indian consumes more lentils…

• a reference commodity basket to measure purchasing power.

• Relative PPP makes predictions about price changes rather than price levels….

Hong Kong’s exception to PPP

……despite a fixed despite a fixed exchange rate exchange rate and no trade and no trade barriersbarriers

Hong Kong’s exception to PPP

• Profit from investment to the special economic zones

• Rich Hong Kong residents spent on the island’s services and nontradables

• Land scarcity made real estate prices soar.

• Floating exchange rates systematically lead to much larger and more frequent short-run deviationsdeviations from relative PPP.

Why price levels are lower in Why price levels are lower in poor countries?poor countries?

positively correlationpositively correlation

• International variations in the prices of nontradables may contribute to price level discrepancies between rich and poor nations.

• Nontradables tend to be more expensive in Nontradables tend to be more expensive in richer countries.richer countries.

• Rich countries have higher capital-labor ratios, the marginal productivity of labor is greater in rich countries than in poor countries. …so does wage level…

Beyond PPP: A general model of Beyond PPP: A general model of long-run exchange rateslong-run exchange rates

• The long-run analysis continues to ignore short-run complications caused by sticky prices.

• Skip over Page417---422: nominal and real exchange rates in the long-run equilibrium.

Two ConclusionsTwo Conclusions1. when all disturbances are monetary in

nature, exchange rates obey relative PPP in the long run.

2. when disturbances occur in outputoutput markets, the exchange rate is unlikelyunlikely to obey relative PPP, even in the long run.

Long run is important!Long run is important!

• Long-run factors are important for the short run because of the central role expectations about the future play in the day-to-day determination of exchange rates.

• The long-run exchange model will provide the anchor for market expectations.

Why does the yen keep rising?

• JapanJapan: 1950-1971: fixed exchange rate

• In about 25 years the dollar had lost 2/3 of its foreign exchange value against the yen!

• After suffering through high inflation in 1973 and 1974, Japan’s leaders began to show a preference for lower inflation than in the U.S.

Balassa-Samuelson EffectBalassa-Samuelson Effect• [P.415] It assumes that the labor forces of p

oor countries are less productive than those of rich countries in tradable sector but that international productivity differences in nontradables are negligible.

• More about Balassa-Samuelson Effect.

Empirical studies Labor productivity growth in U.S. tradables e

xceeded that in U.S. nontradables by 13.2 13.2 %% over the 1973-1983 period. In Japan, productivity growth in tradables outstripped that in nontradables by a massive 73.2 %.73.2 %.

Japan caseJapan case

The greater the gap between factor productivity growth in tradables and nontradables, the greater the rise in the relative price of nontraded goods, on average.

Japan leads the industrial countries in the rate of increase of its nontradables’ prices, and, aside from Nfrom Norway, leads in the gap between traded and nontrorway, leads in the gap between traded and nontraded productivity gainsaded productivity gains.

a higher traded-nontraded productivity growth difference is associated with a higher rate of increase in the relative price of nontradables.

Non-tradables

• For some products, including many services, international transport costs are so steep that these products become nontradables.

Under the flexible-price monetary Under the flexible-price monetary approachapproach

②④

③ ①