Introduction The Law of One Price Purchasing Power Parity A Long-Run Exchange Rate Model Based on PPP Empirical Evidence on PPP and the Law of One Price Explaining the Problems with PPP,Chapter 15 Price Levels and the Exchange Rate in the Long Run,1,Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates International Interest Rate Differences and the Real Exchange Rate Real Interest Parity Summary Appendix: The Fisher Effect, the Interest Rate, and the Exchange Rate Under the Flexible-Price Monetary Approach,Chapter Organization,2,Introduction,The model of long-run exchange rate behavior provides the framework that actors in asset markets use to forecast future exchange rates. Predictions about long-run movements in exchange rates are important even in the short run. In the long run, national price levels play a key role in determining both interest rates and the relative prices at which countries products are traded. The theory of purchasing power parity (PPP) explains movements in the exchange rate between two countries currencies by changes in the countries price levels.,3,The Law of One Price,Law of one price Identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency. This law applies only in competitive markets free of transport costs and official barriers to trade. Example: If the dollar/pound exchange rate is $1.50 per pound, a sweater that sells for $45 in New York must sell for 30 in London.,4,It implies that the dollar price of good i is the same wherever it is sold: PiUS = (E$/) x (PiE) where: PiUS is the dollar price of good i when sold in the U.S. PiE is the corresponding euro price in Europe E$/ is the dollar/euro exchange rate,The Law of One Price,5,Purchasing Power Parity,Theory of Purchasing Power Parity (PPP) The exchange rate between two counties currencies equals the ratio of the counties price levels. It compares average prices across countries. It predicts a dollar/euro exchange rate of: E$/ = PUS/PE (15-1) where: PUS is the dollar price of a reference commodity basket sold in the United States PE is the euro price of the same basket in Europe,6,Purchasing Power Parity,By rearranging Equation (15-1), one can obtain: PUS = (E$/) x (PE) PPP asserts that all countries price levels are equal when measured in terms of the same currency.,7,The Relationship Between PPP and the Law of One Price The law of one price applies to individual commodities, while PPP applies to the general price level. If the law of one price holds true for every commodity, PPP must hold automatically for the same reference baskets across countries. Proponents of the PPP theory argue that its validity does not require the law of one price to hold exactly.,Purchasing Power Parity,8,Absolute PPP and Relative PPP Absolute PPP It states that exchange rates equal relative price levels. Relative PPP It states that the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels, namely: E$/ /E$/, t 1 = US / E, where: t = inflation index So that Er = E t 1 * US / E If less 1 in both 2 sides,Purchasing Power Parity,9,(E$/ ,t - E$/, t 1)/E$/, t 1 = (US, t - E, t )/ E, t If E, t is smaller ，Relative PPP between the United States and Europe would be: (E$/ ,t - E$/, t 1)/E$/, t 1 = US, t - E, t (15-2).中国的名义和实际.ppt,10,Monetary approach to the exchange rate A theory of how exchange rates and monetary factors interact in the long run. The Fundamental Equation of the Monetary Approach Price levels can be expressed in terms of domestic money demand and supplies: In the United States: PUS = MsUS/ L (R$, YUS) (15-3) In Europe: PE = MsE/L (R, YE) (15-4) So that: E = PUS / PE = MsUS* L (R, YE) / MsE *L (R$, YUS),A Long-Run Exchange Rate Model Based on PPP,11,The monetary approach makes a number of specific predictions about the long-run effects on the exchange rate of changes in: Money supplies An increase in the U.S. (European) money supply causes a proportional long-run depreciation (appreciation) of the dollar against the euro，if Y is given. Interest rates A rise in the interest rate on dollar (euro) denominated assets causes a depreciation (appreciation) of the dollar against the euro. Output levels A rise in U.S. (European) output causes an appreciation (depreciation) of the dollar against the euro, if M is given.,A Long-Run Exchange Rate Model Based on PPP,12,Ongoing Inflation, Interest Parity, and PPP Money supply growth at a constant rate eventually results in ongoing inflation (i.e., continuing rise in the price level) at the same rate. Changes in this long-run inflation rate do not affect the full-employment output level or the long-run relative prices of goods and services. The interest rate is not independent of the money supply growth rate in the long run.,A Long-Run Exchange Rate Model