Download Purchasing power parity

C h a p t e r
1 6
Price Levels and
the Exchange
Rate in the
Long Run
To accompany
International Economics, 3e by Sawyer/Sprinkle
PowerPoint slides created by Jeff Heyl
Copyright © 2009 Pearson Education, Inc.
Publishing as Prentice Hall
CHAPTER ORGANIZATION
•
•
•
•
•
Introduction
The Law of One Price
Purchasing Power Parity
The Real Exchange Rate
Summary
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16 – 2
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
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16 – 3
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
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16 – 4
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
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16 – 5
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
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16 – 6
THE LAW OF ONE PRICE
Table 16.1
Purchasing Power Parity and the Big Mac (partial)
Cash and carry
The hamburger standard, July 2007
Big Mac prices
in local
currency
United States
in dollars
Implied
PPP of
the
Actual Dollar
Exchange
Rate July 2nd
Under (–)/Over (+)
Valuation Against
the Dollar, %
$3.41
3.41
Australia
A$3.45
2.95
1.01
1.17
–14
Canada
C$3.88
3.68
1.14
1.05
+8
HK$12.0
1.54
3.52
7.82
–55
¥280
2.29
82.1
122
–33
NZ$4.60
3.59
1.35
1.28
+5
Rouble 52.0
2.03
15.2
25.6
–41
Won 2,900
3.14
850
923
–8
Sweden
SKr33.0
4.86
9.68
6.79
+42
Taiwan
NT$75.0
2.29
22.0
34.5
–33
Hong Kong
Japan
New Zealand
Russia
South Korea
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16 – 7
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
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16 – 8
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
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16 – 9
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
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16 – 10
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”
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16 – 11
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
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16 – 12
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
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16 – 13
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
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16 – 14
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
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16 – 15
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
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16 – 16
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
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16 – 17
PURCHASING POWER PARITY
Table 16.2
The Dollar/Pound Exchange Rate and Relative U.S./U.K.
Price Levels, 1966–2006
3.50 –
3.00 –
2.50 –
2.00 –
1.50 –
1.00 –
1966 69
72
75
78
81
84
Exchange Rate
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87
90
93
96
99 2002
2005
U.S./U.K. Price Levels
16 – 18
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”
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16 – 19
PURCHASING POWER PARITY
Table 16.3
Percentage Change in the Exchange Rate and the
Percentage Difference in Relative Prices, 1966–2006
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
%∆ in the Exchange Rate
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87
90
93
96
99 2002
2005
% U.S. Prices – % U.K. Prices
16 – 20
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
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16 – 21
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
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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
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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
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16 – 24
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
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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
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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
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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
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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
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16 – 29
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
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16 – 30
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)
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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)
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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
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16 – 33
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
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16 – 34
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
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16 – 35
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
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16 – 36
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
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16 – 37
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]
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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”
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16 – 39
THE REAL EXCHANGE RATE
Table 16.4
The Dollar/Pound Exchange Rate and The Real
Dollar/Pound Exchange Rate, 1966–2006
4.00 –
3.50 –
3.00 –
2.50 –
2.00 –
1.50 –
1.00 –
1966 69
72
75
78
81
84
Exchange Rate
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
87
90
93
96
99 2002
2005
Real Exchange Rate
16 – 40
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
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16 – 41
THE REAL EXCHANGE RATE
Table 16.5
China’s Nominal and Real Effective Exchange Rate,
1997–2006
150 –
140 –
130 –
120 –
110 –
100 –
90 –
80 –
70 –
60 –
1990 91 92 93 94 95 96 97 98 99 2000 01
Real Exchange Rate
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02
03
04
05
06
Nominal Exchange Rate
16 – 42
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
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16 – 43
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
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16 – 44
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
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16 – 45
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
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16 – 46
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
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16 – 47
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
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16 – 48
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
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16 – 49
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
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16 – 50
SUMMARY
1. The law of one price states that, disregarding
barriers to trade and transportation costs,
identical goods sold in competitive markets
should cost the same everywhere when prices are
expressed in terms f the same currency
2. Purchasing power parity (PPP) is an
extrapolation of the law of one price to a group
of tradable goods and states that a bilateral
exchange rate should equal the ratio of the price
level in one country to the price level in the other
country
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16 – 51
SUMMARY
3. The absolute version of PPP is based on the
absolute prices in two countries. The relative
version of PPP is based on the difference in the
percentage change in the national price levels
over any given period of time.
4. In the short run, the exchange rate observed in
the market can and does deviate significantly
from that predicted by either version of the PPP
5. Prices may not equalize perfectly between
countries because of trade barriers, difference in
competitive conditions, taxes and regulations,
and the presence of nontradable goods
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16 – 52
SUMMARY
6. Long-run changes in the nominal exchange rate
are a function of relative prices between the two
countries
7. The real exchange rate is the nominal exchange
rate adjusted for changes in the price level of the
two countries
8. There are three major factors that would cause
the real exchange rate to change in the long run,
changes in foreign demand for domestically
produced products, changes in a country’s
productivity, and changes in the real interest rate
between countries
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16 – 53