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Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Slides for International FinancePurchasing Power Parity (KO Chapter 15)
Alan G. Isaac
American University
2010-10-03
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Preview
Purchasing power parityCommodity price parityAbsolute PPP vs. Relative PPP
Classical model of price determinationLR neutrality of moneyFisher effectmagnification effect
Monetary approach to flexible exchange ratesExchange rates in the long run
Real exchange rate determinationPPP shortcomingsnominal vs. real shocks
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Law of One Price
Law of One Price (LOP): identical goods have identical prices.
Commodity Price Parity (CPP): the international LOP.
Pi = EP∗i
Economic “laws” are just points of reference:
not like physical laws
violations expected
violations stimulate investigation
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Commodity Price Parity (CPP)
Example: - Two fast-food restaurants: one in New York, and oneacross the border in Montréal. - assume markets are competitive andthat transportation costs and barriers between markets are notimportant.
PUSburger = (0.95USD/CAD) × PCA
burger
where PUSburger = price of burger in New York, PCA
burger = price of burgerin Montréal, and 0.95USD/CAD is the CAD-USD exchange rate.
CPP applies the law of one price: the price of the same burger (usinga common currency to measure the price) in the two cities must be thesame
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
CPP Example
On 30 September 2010
1oz of gold sold in New York for USD 13071 oz also sold in London for GBP 830.One GBP sold in both locations for about USD 1.575.
Gold satisfies CPP: 1307 = 1.575 * 830
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Exchange Rate Models: SR vs. LR
Models predict how exchange rates behave.
SR model: “Keynesian“ story about moneymoney � interest rates � exchange rate
LR model: “Classical” story about moneymoney � prices � exchange ratemoney growth � inflation � depreciation
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
“Long-Run” Models
Meaning of LR:
model specifichere: essentially the simplest “Classical“ model
all prices adjust; all markets in equilibriumgood, services, factors of production
Purpose of LR models
predict future tendencies
anchor LR expectations
do not describe SR exchange rate behavior
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Real Exchange Rate
The real exchange rate (q): the rate of exchange of goods andservices across countries.I.e., the relative price of goods and services across countries.
q is the price of foreign goods and services in terms of domestic goodsand services:
E P* = domestic currency price of foreign goodsP = domestic currency price of domestic goodsq = E P* / P
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Real Exchange Rate Depreciation
q = E P* / P
real depreciation: a rise in qforeign commodities cost more in terms of domestic commodities
Example: a real depreciation of the USD
US products buy fewer foreign productsour ability to trade off US goods for EU goods declines
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Real Exchange Rate Appreciation
q = E P* / P
real appreciation: a fall in qforeign commodities cost less in terms of domestic commodities
Example: a real appreciation of the USD
US products buy more foreign productsour ability to trade off US goods for EU goods improves
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Purchasing Power Parity (PPP)
Core PPP idea:
real exchange rate (q) is constantexchange rate movements match relative price movements
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Absolute Purchasing Power Parity
Absolute purchasing power parity: P = E P*
P = level of domestic prices (e.g., US)P* = level of foreign prices (e.g., CA)E = exchange rate (e.g., CAD-USD 0.95)
the application of the law of one price across countries for“baskets” of goods and services.
average price levels determine the exchange rate.
the domestic currency has the same purchasing power in allcountries
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Absolute Purchasing Power Parity (Absolute PPP)
Absolute purchasing power parity: E = P/P*
Example:
P = USD 300 per basketP* = EUR 200 per basketabsolute PPPE = P/P* = USD 300/EUR 200 = 1.5 USD/EUR(the EUR-USD exchange rate is 1.5)1.5 USD buys the same amount of goods as 1 EURtherefore 1.5 USD buys 1 EUR
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Two Forms of PPP
Absolute PPP: E = P/P*Exchange rates equal the level of relative average prices acrosscountries.
Relative PPP: E = q P / P*Exchange rates are proportional to the level of relative averageprices across countries
Both: exchange rate changes (depreciation) match changes in prices(inflation) between two periods:
Et −Et−1
Et−1= πt −π
∗t
where πt = inflation rate from period t-1 to t.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsAbsolute vs. Relative
Two Forms of PPP
Relative PPP: E = q P / P*q relatively constant
Absolute PPP: E = P / P*q = 1
Conditions for absolute PPP:
CPP for every commodityidentical index-basket construction
Absolute PPP is essentially the LOP for price indices.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Monetary Approach to Flexible Exchange Rates (MAFER)
MAFER Assumptions:
PPP (absolute or relative)
Classical model of price determination
The monetary approach uses monetary factors to predict howexchange rates adjust in the long run.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Classical Model of Price Determination
Money market in equilibriumM/P = L(R,Y)
Prices flexible and move to clear money marketP = M / L(R,Y)
implication: inflation driven by money growth
P = M− L
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Money Growth and Inflation
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Classical Model of Price Determination
prices are flexible
prices adjust so that the real money supply (M/P) equals realmoney demand (L)P = M / L(R, Y)P* = M* / L(R*, Y*)P/P* = (M/M*) / (L/L*)
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
MAFER Predictions
positive money supply shock:
^P and ^E proportionallyR does not change
positive output shock:
_P and _E roughly proportionallyR does not change
positive money growth rate shock:
P and E: inflation and depreciation increase in step^R (in step with inflation; the Fisher effect)P and E: initial jump (magnification effect)
We need to explore these predicitons.Modifications of the model will modify these predictions.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Monetary Shock: Compare and Contrast
SR model:
“sticky” prices^M � ^M/P^M � exchange rate overshootingSR movement > LR movement
MAFER:
“flexible” prices^M � ^P proportionally: M/P unchanged^M � ^E proportionally: no overshootingneutrality of money (even in SR!)no real changesSR movement = LR movement (but it’s just a LR model)
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Change in Growth of M
Suppose that the U.S. central bank unexpectedly increases thegrowth rate of the money supply at time t0 by 5% per year.
The inflation rate rises by 5% per yearπnew = π +Δπ = π +5%
According to the Fisher effect, the interest rate in the U.S. willtherefore also rise 5%.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Fisher Effect
Fisher Effect: ^ πe � ^ RImplication: a sustained rise in inflation eventually causes anequal ^R
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Irving Fisher (1867–1947)
1888 BA from Yale
1891 First Yale PhD in Econ
17 Oct 1929 Most famous pre-diction: “Stock prices havereached what looks like apermanently high plateau.”(Recall that 29 Oct 1929was “Black Tuesday”: NYSEshare prices collapse)
1930 The Theory of Interest
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Permanent Increase in Domestic Money Growth
M
M0
t0 t0time time
M
Note: M is measured on a ratio scale. Compare KO 8 Fig 15-1
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
^M Growth � ^P Growth
M
M0
t0 t0time time
P
Note: M is measured on a ratio scale. Compare KO 8 Fig 15-1
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Permanent Increase in Domestic Money Growth
M R
M0
t0 t0
R1
R1 +Δπ
time time
Note: M is measured on a ratio scale. Compare KO 8 Fig 15-1
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Effect of R on Exchange Rates
The increase in nominal interest rates decreases the demand forreal monetary assets.
For the money market to be in equilibrium at the new R, the pricelevel must rise so that
P = M / L(R, Y)
In order to maintain PPP, the exchange rate must rise (the dollarmust depreciate) proportionately so that
E = q P / P*
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
MAFER and ^Money Growth
Higher M growth raises inflation and therefore R.
^R � _L (lower demand for real monetary assets)
_L � _M/P
For money market equilibrium at ^R, we must see ^P so that
P = M / L(R, Y)
� ^E (to maintain PPP)
Thereafter, M and P rise faster by Δπ , as does E (the direct rate).In order to maintain PPP, the domestic currency continue to depreciateproportionately.
E = q P / P*
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
^M Growth: Impact (t0) Effect (MAFER)
E1
Q
L(R,Y1)
Q1
R10 returns
R∗+ Ee1
ESR
R1 +Δπ
Q2
R∗+ Ee2
Note: Compare KO 8 Figure 15A-1Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Fig. 15A-1: Impact (t0) Effect of ^M Growth (MAFER: GoodsPrices Are Flexible)
Source: KO 8 Figure 15A-1
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Permanent Increase in Domestic Money Growth
P E
P0
t0 t0
E0
time time
Note: P and E are measured on a ratio scale. Compare KO 8 Fig 15-1
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Permanent Increase in Domestic Money Growth
Source: KO 8 Fig 15-1
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Permanent ^M Growth (MAFER)
Permanent ^M growth causes permanent ^P growth
the domestic currency must depreciate when domestic inflationexceeds foreign inflation (by PPP)
Furthermore:
↑ π →↑ πe→↑ R→↓ L→↑ P,E
Persistent domestic inflation increases expected inflation.
Higher expected inflation causes a rise in the domestic nominalinterest rate (by the Fisher effect).
Higher R reduces desired real balances.
Therefore, there is a magnification effect on P and E.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Magnification Effect
Sustained higher money growth �
sustained higher inflation
sustained higher depreciation
Fisher effect:
R = Rreal +πe
Magnification effect:
^ inflation � ^R^R � _L � _M/PP must move more than M
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Inflation in Zaire
1
10
100
1000
10000
100000
1e+006
1e+007
1e+008
1e+009
01/90 01/91 01/92 01/93 01/94 01/95 01/96
Mon
ey, P
rice
s, a
nd E
xcha
nge
Rat
es: 0
1/90
= 1
Exchange RateCPI
Currency
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Shortcomings of PPP
Little empirical support for absolute PPP.The prices of identical commodity baskets, when converted to asingle currency, differ substantially across countries.
Relative PPP is more consistent with data, but it also poorlypredicts exchange rates in the short run.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Fig. 15-2: The Yen/Dollar Exchange Rate and RelativeJapan-U.S. Price Levels, 1980-2006
Source: IMF, International Financial Statistics. Exchange rates andprice levels are end-of-year data.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Deviations from PPP
PPP may not hold due toviolations of the law of one price
Trade barriersnon-tradable productsImperfect competition
divergent price index construction (different baskets of goods andservices)
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Deviations from PPP: Barriers to Trade
Barriers to frictionless trade are the most fundamental source of PPPdeviations:Trade barriers and non-tradable products � one price need not hold intwo markets.
Transport costs
governmental trade restrictionsnon-tradeable goods
some services are not readily tradable (classic example, haircuts).
The greater the barriers to trade, the greater the possibledeviation from PPP.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Deviations from PPP: Imperfect Competition
If markets can be segmented, imperfect competition may result inprice discrimination.
pricing to market: a firm sells the same product for different prices indifferent markets to maximize profitsprice depends on the elasticity of demand in each market
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Deviations from PPP: Measurement
Price index construction differs across countries
differences in how representative groups (“baskets”) of goods andservices are measured.
differences in the “weights” given various goods and services
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Computing Big Mac PPP
Data
E: current exchange rate (direct rate; domestic terms)P: local priceP*: US price
Computations:
Eppp = P/P*overvaluation = Eppp/E -1
Alternative Computations:
q = EP*/Povervaluation = 1/q - 1
Logarithmic approximation:
overvaluation = -log(q)
Since ln(1+ x)≈ x , you can get a rough approximation of overvaluation as − log(q). (This works best when q is near 1.)
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Switzerland (CHF) Example:
Data:
E = 1.05P = 6.50P* = 3.73
Computations:
Eppp = P/P* = 6.50/3.72 = 1.75overvaluation = (Eppp/E -1) = (1.75/1.05 - 1) = 66%
Alternative Computations:
q = EP*/P = 1.05 * 3.73 / 6.50 = 0.602overvaluation = 1/q - 1 = 1/0.602 - 1 = 66%
Logarithmic approximation:
overvaluation = -ln(q) = -ln(0.602) = 0.51
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
China (CNY) Example:
Data:
E = 6.78P = 13.2P* = 3.73
Computations:
Eppp = P/P* = 13.2/3.72 = 3.55overvaluation = (Eppp/E -1) = (3.55/6.78 - 1) = -48%
Alternative Computations:
q = EP*/P = 6.78 * 3.73 / 13.2 = 1.92overvaluation = 1/q - 1 = 1/1.92 - 1 = -48%
Logarithmic approximation:
overvaluation = -ln(q) = -ln(1.92) = -65%
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Law of One Price for Hamburgers?
UA
HLK
RH
KD
CN
YTH
BPH
PM
YR
EG
PR
UB
TW
DZ
AR
PK
RM
XN
IDR
PLN
EEK
SA
RLT
LLV
LK
RW
AED
SG
DH
UF
CLP
CZ
KG
BP
PEN
AR
SN
ZD
JPY
UYU
CR
CA
UD
ILS
TR
YC
AD
EU
RC
OP
DK
KB
RL
CH
FSEK
NO
K
-100
-50
0
50
100
Perc
enta
ge O
verv
alu
ati
on
Data Source: http://www.economist.com/node/16646178?story_id=16646178
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Penn Effect
Naive GDP comparison: relative GDP = E GDP* / GDP
Penn effect: naive comparisons systematically exaggerate real percapita income ratios between poor and rich
Empirics Penn studies of Kravis-Heston-Summersreal-income estimates, using actual local prices and incomes
Theory Balassa (1964) and Samuelson (1964)Also: David Ricardo and Roy Harrod
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Paul Samuelson (1915-2009)
1941 PhD from Harvard
1947 Foundations of EconomicAnalysis
1948 Economics: An Introduc-tory Analysis
1970 “Nobel” prize
1973 famous prediction (in histextbook): the Soviet Unionwill catch up to the UnitedStates in per capita incomeby 1990
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Balassa-Samuelson Critique
Price indices contain traded and nontraded goodsP = f (Pt ,Pnt)
Shifts in relative price can disrupt PPPRicardo (1817): high manufacturing productivity� costlynontraded goodsSamuelson (1964)
disparate postwar growth ratesincome growth correlated with traded goods productivity
Dollar should look overvalued against low growth countries
even if Pt = EP∗t
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Fig. 15-3: Price Levels and Real Incomes, 2004
Source: KO Figure 15-3 (Data Source: Penn World Table, Mark 6.2)
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Price Levels and Real Incomes, 2007
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Price Levels and Real Incomes, 2007
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Price Levels and Real Incomes, 2007
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Endogenous LR Real Exchange Rate
PPP (absolute or relative) = a constant real exchange rate
E = q P / P* (with q constant)� nominal exchange rate movements are determinedby movements in relative price level:
A more general story tries to explain changes in the real exchangerate.Movements in nominal exchange rate then have two sources:
E = q+ (P/P∗)
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Determination of the Long-Run Real Exchange Rate
Relative demand depends on relative prices (i.e., on prices orexchange rates), but relative output does not.
LR output (Y and Y*) depends onfactors of productiontechnology.
LR demand (AD and AD*) depends on:the relative price of foreign products (q=EP*/P)Relative prices determine the demand for domestic productsrelative to foreign products.when the real exchange rate depreciates, the relativedemand for domestic commodities rises.
Equilibrium:Y/Y* = AD/AD*relative supply matches the relative demand (so there is notendency for the relative price to change).
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Determination of the Long-Run Real Exchange Rate
q
q1
Y/Y ∗ relative output
RS RD
Note: compare KO 8 Fig 15-4
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Demand Shocks and LRRER
Situation: an increase in relative demand for domestic products
(^Ex or _Im) � _qa real appreciation of the domestic currencythis is a rise in the price of domestic goods (P) relative to the priceof foreign goods (EP*)
real appreciation makes our exports more expensive and ourimports less expensive� _ relative demand� restoring equilibrium
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Demand Shocks and LRRER
q
q1
Y/Y ∗ relative output
RS RD
RD’
q2
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Supply Shocks and LR RER
Situation: an increase in relative supply of domestic US products
(^Y or _Y*) � ^qa real depreciation of the domestic currencythis is a rise in the price of foreign goods (EP*) relative to the priceof domestic goods (P)
real depreciation makes our exports less expensive and ourimports more expensive� ^ relative demand� restoring equilibrium
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Supply Shocks and LRRER
q
q1
Y1/Y ∗ relative output
RS’ RDRS
q2
Y2/Y ∗
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
The LR RER (Summary)
Endogenizing the real exchange rate
produces a more general model of exchange ratedetermination
The monetary approach still applies:
increases in monetary levels leading to price level increases.increases in monetary growth rates lead to persistentinflation (and corresponding changes in expectations).
But now real factors also matter:
increases in relative demand for domestic products leads toa real appreciation.increases in relative supply of domestic products leads to areal depreciation.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Nominal Exchange Rate Determination Redux
How does this change our theory of nominal exchange ratedetermination?
E = q P / P*
Monetary shocksPPP still holdswe have the same predictions as before.no changes in the real exchange rate
Real demand shocksthe real exchange rate changes (^AD � _q)the nominal exchange rate adjusts to produce theequilibrium real exchange rate
Real output shocksthe real exchange rate changes (^Y � ^q)the nominal exchange rate situation is more complex. . .
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
The Real Exchange Rate Approach to Exchange Rates(cont.)
With an increase in the relative supply of domestic products, thereal exchange rate adjusts to make the price/cost of domesticgoods depreciate, but also the relative amount of domestic outputincreases. - This second effect increases the demand of realmonetary assets in the domestic economy:
P = M / L(R,Y)
Thus level of average domestic prices is predicted to decreaserelative to the level of average foreign prices.The effect on the nominal exchange rate is ambiguous:
E = q P / P*
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
LR Model Summary: Effects of Money Market and OutputMarket Changes on E
^ M � proportional ^E
^ M* � proportional _E
^ AD � _ E
^ AD* � ^ E
^ Y � ? E
^ Y* � ? E
Compare KO 8 Table 15-1
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Interest Rate Differences
Anticipated changes in q show up in the interest differential:
qe−qq
=Ee−E
E− (πe−π
∗e)
R−R∗ =Ee−E
E
R−R∗ =qe−q
q− (πe−π
∗e)
R - R* is the sum of:The expected rate of real depreciation (i.e., of the value ofdomestic goods relative to foreign goods)The inflation differential between the domestic economy and theforeign economy
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Real Interest Rates
Real interest rate: inflation-adjusted interest ratemeasured in terms of real output
savers can buy more goods and services when their assetspay real interestborrows can buy fewer goods and services when they mustpay real interest on their borrowing
Ex ante real interest rate: expected real interest rate
re = R−πe
Here πe = expected inflation rate and R = nominal interest rate.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Real Interest Parity
Real interest rate differentials (across countries) must equal expectedchanges in the real exchange rate.
re− r∗e = (R−πe)− (R∗−π
∗e) (1)
R−R∗ = (qe−q)/q+(πe−π∗e) (2)
(R−πe)− (R∗−π
∗e) = (qe−q)/q (3)
re− r∗e = (qe−q)/q (4)
RIP says that the real interest rate differential between countriesequals to the expected change in the relative price of goods andservices between countries.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Expected PPP and Real Interest Parity
If financial markets expect (absolute or relative) PPP to hold, thenexpected exchange rate changes will equal expected inflation betweencountries:
(Ee−E)/E = πe−π
∗e expected PPP
R−R∗ = (Ee−E)/E interest parity
R−R∗ = πe−π
∗e
R−πe = R∗−π
∗e
We get an international version of the Fisher effect, and real interestparity.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Real Interest Parity? (3 Month Tbills and Core Inflation)
Source: World Economic Outlook, 2010-04, Figure 1.8
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Summary
The law of one price: the same good in different competitive marketsmust sell for the same price(Assume: transportation costs and barriers between markets arenot important.)
Purchasing power parity: the law of one price for price indexes
Absolute PPP: changing currencies does not change yourpurchasing power.
Relative PPP the nominal exchange rate moves withrelative price levels
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Summary (cont.)
monetary approach to flexible exchange rates:
assumes PPP and the Classical theory of pricesChanges in the growth rate of the money supply influenceinflation and exchange rates.Expectations about inflation influence the exchange rate.The Fisher effect shows that differences in nominal interestrates are equal to differences in inflation rates.
Empirical support for PPP: weak.Trade barriers, non-tradable products, imperfect competition anddifferences in price measures may cause the empiricalshortcomings of PPP.
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Summary: Real Interest Parity
Real interest rate: inflation-adjusted interest rate(how much purchasing power savers gain and borrowers giveup)
Real interest parity: real interest rate differential equals expectedrate of real exchange rate depreciation
Alan G. Isaac Slides for International Finance
Purchasing Power ParityMonetary Approach to Flexible Exchange Rates (MAFER)
Introductory ConceptsLR Real Exchange Rate
Summary (cont.)
real exchange rate: the domestic product cost of foreign products.
real exchange rate approach to exchange rates:
generalizes the monetary approach (allows PPP violations)predicts that changes in relative demand and relative supplyof products influence real and nominal exchange rates.allows deviations from real interest parity(Real interest rate differences now equal the expectedchange in the real exchange rate)
Alan G. Isaac Slides for International Finance