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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