Ch.5 - Chapter 5 Price Levels and the Exchange Rate in the Long Run Preview Law of one price Purchasing power parity Long-run model of exchange rates

# Ch.5 - Chapter 5 Price Levels and the Exchange Rate in the...

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Chapter 5 Price Levels and the Exchange Rate in the Long Run
Preview Law of one price Purchasing power parity Long-run model of exchange rates: monetary approach Relationship between interest rates and inflation: Fisher effect Shortcomings of purchasing power parity Long-run model of exchange rates: real exchange rate approach Real interest rates
Law of One Price • The law of one price : the same good in different competitive markets must sell for the same price in competitive markets free of transportation costs and trade barriers. Suppose the price of pizza at one restaurant is \$20, while the price of the same pizza at an identical restaurant across the street is \$40. – Many people will buy the \$20 pizza, few will buy the \$40 one. – Prices would tend to adjust until one price is achieved across markets (across restaurants).
Consider a pizza restaurant in Seattle and one across the border in Vancouver. The law of one price says that the price of the same pizza (using a common currency to measure the price) in the two cities must be the same: P pizza US = ( E US\$/C\$ ) x ( P pizza Canada ) P pizza US = price of pizza in U.S. P pizza Canada = price of pizza in Canada E US\$/C\$ = U.S. dollar/Canadian dollar exchange rate
Purchasing Power Parity (PPP) Purchasing power parity is the application of the law of one price across countries for a representative group ( basket ) of goods and services. P US = ( E US\$/C\$ ) x ( P Canada ) P US = level of average prices in the U.S. P Canada = level of average prices in Canada E US\$/C\$ = U.S. dollar/Canadian dollar exchange rate
PPP implies that the exchange rate is determined by levels of average prices E US\$/C\$ = P US / P canada e.g. If P US =US\$200 per basket P canada =C\$400 per basket E US\$/C\$ = P US / P canada =C\$400/US\$200 = C\$2/US\$1. – PPPP predicts that people in all countries have the same purchasing power with their currencies: 2 Canadian dollars buy the same amount of goods as 1 U.S. dollar, since prices in Canada are twice as high.
Absolute PPP : Exchange rate equals the ratio of two countries’ price levels. E \$/€ = P US / P EU Relative PPP : changes in exchange rates equal changes in prices (inflation) between two periods: ( E \$/€, t – E \$/€, t –1 )/ E \$/€, t –1 = US, t EU, t where t = inflation rate from period t –1 to t t =( P t – P t –1 )/ P t –1 Absolute PPP Vs. Relative PPP If absolute PPP holds, relative PPP must hold. If absolute PPP does not hold, relative PPP may still hold.
The law of one price applies to individual commodities (i.e., commodity i) E \$/€ = P i US /P i EU PPP applies to the general price level, which is a composite of the prices of all the commodities in the reference basket E \$/€ = P US / P EU PPP and the Law of One Price
Monetary Approach to Exchange Rates • It uses monetary factors to predict how exchange rates adjust in the long run, based on the absolute PPP.

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