Chapter 16 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
The Behavior of Exchange Rates •What models can predict how exchange rates behave?
The Behavior of Exchange Rates (cont.) • The long-run models are not intended to be completely realistic descriptions about how exchange rates behave, but ways of representing how market participants may form expectations about future exchange rates and how exchange rates tend to move over long periods.
Law of One Price •Why? Suppose the price of pizza at one restaurant is $20, while the price of the samepizza at an identical restaurant across the street is $40.•What do you predict will happen?
Law of One Price (cont.) • Consider a pizza restaurant in Seattle and one across the border in Vancouver. • The law of one price says that the price of the same pizza (using a common currency to measure the price) in the two cities must be the same if markets are competitive and transportation costs and barriers between markets are not important. P pizza US = ( E US$/C$ ) x ( P pizza Canada ) P pizza US = price of pizza in Seattle P pizza Canada = price of pizza in Vancouver E US$/C$ = U.S. dollar/Canadian dollar exchange rate
Purchasing Power Parity • Purchasing power parity is the application of the law of one price across countries for all goods and services, or for representative groups ( “ baskets ” ) 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
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