Chapter 15 Inflation and Interest Rates in Open Economies

Chapter 15 Inflation and Interest Rates in Open Economies -...

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Chapter 15 Inflation and Interest Rates in Open Economies © Leddin & Walsh 2013
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Road map: 1. Purchasing power parity (PPP) 2. The PPP exchange rate 3. PPP and the real exchange rate 4. Harmonized competitiveness indicator 5. Relative PPP 6. PPP under flexible exchange rates 7. PPP under fixed exchange rates 8. Uncovered interest rate parity theory 9. Irish and UK interest rates 10. Interest rates in the Euro area. © Leddin & Walsh 2013
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1. Purchasing Power Parity (PPP) Prices of similar goods expressed in a common currency should be similar. Based on arbitrage. Buy cheap, sell expensive to make profit. Actions should lead to a convergence of prices. © Leddin & Walsh 2013
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PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels. Absolute PPP, can be stated as: P EA e = P US (1) © Leddin & Walsh 2013
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P  e = P * Example: Levi Jeans, P Irl = €50 in Limerick, P us = $100 in New York. If e = $/€ = 2, PPP holds. If e 2, PPP does not hold. © Leddin & Walsh 2013
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Why PPP May Not Hold Transport costs. Trade restrictions. Different indirect taxes. (VRT on Irish cars/motorbikes.) Lags in adjusting prices to exchange rate fluctuations. Product differentiation. Exploit monopoly power and engage in price fixing. Theory applies to traded goods only. Non-traded goods (housing, public sector services, hotel rooms, restaurants, etc. ) are excluded. © Leddin & Walsh 2013
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3. PPP and the Real Exchange Rate Define the real exchange rate as: = (P  e)/ P * Where: P = Domestic (Irish) price e = Nominal exchange rate P * = Foreign price = Real exchange rate Greek letter epsilon © Leddin & Walsh 2013
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Interpretation: 1. The nominal exchange rate adjusted for relative prices. 2. Ratio of Irish and foreign (USA) prices expressed in a common currency.
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