international finance 130440-1165 exchange rate movements in the long term international finance...

International Finance 130440-1165

Exchange rate movements in the long term

International Finance 130440-1165

International Finance 130440-1165

Lecture outline

The law of one price

The purchasing power parity (PPP) theory

The monetary model and PPP

Extensions of the PPP theory

International Finance 130440-1165

The law of one price

Assumption: no barriers to trade, no transportation costs

The price of identical goods should be equal in different

countries if expressed in the same currency

Example:

If ER=1,5 USD/GBP PGBP=30 GBP PUSD=45 USD

International Finance 130440-1165

The law of one price

PGBP>PUSD imports from USA price

falls in GB

PUSD= ER USD/GBP*PGB

International Finance 130440-1165

The purchasing power parity theory

The purchasing power (PP) of a currency is

reflected in the nominal price of a reference

basket of goods and services.

If one can buy the same basket for 30 GBP and

for 45 USD the PP of the GBP is higher than of

the USD

International Finance 130440-1165

The purchasing power parity theory

The nominal ER of two currencies

conforms the PPP if for a unit of a

currency we can purchase the same

basket of goods in our country and abroad

International Finance 130440-1165

The purchasing power parity theory

The PP of two currencies is measured

with the real ER

RER= NER* Pn/Pa

NER*Pn/Pa=1 RER=1

International Finance 130440-1165

The purchasing power parity theory

Overvalued currency if RER>1 it means:

NER* Pn>Pa

Undervalued currency if RER<1 it means:

NER* Pn>Pa

Arbitrage Pn and NER decreases (or

increases) so RER=1

International Finance 130440-1165

The absolute and relative version of PPP theory

The absolute version seem not to be

confirmed empirically

RER does not equal 1!

International Finance 130440-1165

The PLN RER vs EUR

Źródło: R. Kelm, Model behawioralnego kursu równowagi złotego do euro, Bank i Kredyt 41 (2), NBP,

Warszawa 2010.

International Finance 130440-1165

The absolute and relative version of PPP theory

The relative version of the theory: the NER changes of one currency equal the

difference between the domestic price changes

and abroad

(NERt-NERt-1)/NERt-1=Πnt-Πat

International Finance 130440-1165

Inflation differentials

According to the PPP theory the changes

in the nominal ER are due to inflation

differentials

Πn=3% Πa=1% the national currency

should depreciate at 2% p.a.

NERt/NERt-1=101/103=98%

International Finance 130440-1165

Empirical verification of PPP

Empirical proofs only in a longer term

The PPP RER is offen used to compare

wealth in different countries

Problem- consumption structure

Depending on the reference basket- there

are several RER PPP

International Finance 130440-1165

The monetary model based on PPP

Assumption: NER= Pn/Pa so the PPP is fullfilled

Pn=Mn/L(in, Yn)

Pa= Ma/L(ia, Ya)

NER is determined in the long term by the

relative money supply and demand in two

countries

International Finance 130440-1165

The monetary model based on PPP

Money supply increase price increase

currency depreciation

Interest rate increase decrease of money

demand by constant money supply increase of

prices depreciation

Production increase money demand increase

price decrease appreciation

International Finance 130440-1165

The monetary model based on PPP

Puzzling evidence??

The influence of interest rate changes on

ER depends on the reason why the

interest rate changed!

International Finance 130440-1165

The monetary model based on PPP

Raising money supply Persistent inflation

The interest rate parity and PPP

If people expect the PPP theory to hold, the

interest rate difference between two countries

equals the difference between the expected

inflation in those two countries

International Finance 130440-1165

The monetary model based on PPP

Πe=(Pe-P)/P

(NERe-NER)/ NER= Πen- Πea

in= ia+ (NERe-NER)/NER

in- ia = Πen- Πea

International Finance 130440-1165

The Fisher effect

in- ia = Πen- Πea

The increase of the expected inflation in

one country causes in a long term an

identical increase of the interest rate

denominated in the currency of this

country

International Finance 130440-1165

The Fisher effect

The effect holds only in long term

It explains the paradox of the relation

between ir changes and er changes

In the short term- sticky prices

International Finance 130440-1165

The empirical verification of the relative PPP theory

Źródło: R. Kelm, Model behawioralnego kursu równowagi złotego do euro, Bank i Kredyt 41 (2), NBP,

Warszawa 2010.

International Finance 130440-1165

Main factors impeding PPP

Barriers to trade

Non-tradable goods

Incompetitive market structures

Differences in consumption structures

and prices

The Ballassa-Samuelson effect

International Finance 130440-1165

Barriers to trade

Transportation cost

Trade policy

Barriers to capital movement

International Finance 130440-1165

Nontradable goods

Services

No international price relation

Great share of nontradables in GDP

International Finance 130440-1165

The Big Mac Index

International Finance 130440-1165

Incompetitive market structures

Market segmentation

Price discrimination

Dumping prices

International Finance 130440-1165

Consumption structure differences

Different measures of prices and inflation Majority of consumption- national

products Differences in consumption structure

influence PPP ER

International Finance 130440-1165

The Balassa-Samuelson effect

The price level in countries with higher labour

productivity grwoth is higher than in countries

with lower productivity growth

Differences in productivity growth in tradables

and nontradables sectors

Productivity growth wages growth in both

sectors

International Finance 130440-1165

The Balassa-Samuelson effect

Higher inflation in the nontradables sector

Effect- countries with higher

productivity higher price level RER

>1

Especially- cathing up countries

International Finance 130440-1165

Extending the PPP theory

Real ER movements

Long term equilibrium on the FX market

International long term ineterest rate

differentials

International Finance 130440-1165

Real exchange rate movements

RER depreciation

RER appreciation

Example: NER USD decreases from 0,7 to 0,6 EUR/USD

ΠEUR= 105 and ΠUSD=130

This means USD RER appreciation

RERt/RERt-1= (NERt/NERt-1)* Πn/Πa

=(0,6/0,7)*(130/105)= 1,06

International Finance 130440-1165

Long term equilibrium on the FX market

NER=RER*(Pn/Pa)

by given RER the NER is influenced by

money demand and supply

by given money demand and supply NER

is influenced by RER

International Finance 130440-1165

Long term equilibrium on the FX market

Shifts in relative money supply Shifts in relative money supply growth

rates Shifts in relative demand for products Shifts in relative supply of products

International Finance 130440-1165

Long term equilibrium on the FX market

If all shock are monetary in a long term

the RER conforms PPP!!!

Monetary shocks influence only the PP

which changes the ER

If real shocks occure- the ER does not

conform to PPP

International Finance 130440-1165

International long term interest rate differentials

Interest rate differentials depend not only on

inflation expectations but also on expected RER

in-ia= (NERe-NER)/NER +(Πen - Πea )

The interest rate differential equals the expected

real depreciation of the ER and expected

inflation differentials

International Finance 130440-1165

Real ineterest rate parity

The expected RER changes equal the

expected real interest rate changes

rine-riae=(RERe-RER)/RER

International Finance 130440-1165

Summing up

No empirical evidence of the absolute

version of the PPP theory

NER*Pn/Pa=1 RER=1

The relative version of the PPP theory

(NERt-NERt-1)/NERt-1=Πnt-Πat

Empirical evidence only in the long term

International Finance 130440-1165

Summing up

The monetary model based on PPP

The Fisher effect

in- ia = Πen- Πea

Factors impeding the PPP theory

Extensions of the PPP theory

International Finance 130440-1165

References

P. Krugman, M.Obstfeld, International economics: theory and policy. Part II, Pearson, Addison Wesley, Boston 2009

R. Kelm, Model behawioralnego kursu równowagi złotego do euro, Bank i Kredyt 41 (2), NBP, Warszawa 2010

M. Rubaszek, Economic convergence and the fundamental equilibrium exchange rate in Poland, Bank i Kredyt 40 (1), NBP, Warszawa 2009.

R. Clarida, J. Gali, Sources of real exchange rate fluctuations: how importanta are nominal shocks?, NBER Working Paper, 1994.

M. Wagner, J. Hlouskova, What’s really the story with this

Balassa-Samuelson Effect in the CEECs?, Diskussionschriften, Universität Bern, 2004