1 Price Law
In perfectly competitive markets, the prices of identical goods will be = across markets.
($) = P
where S = spot
$4.08 = £2 * $2.04/£ (Big Mac in NY and London) (1)
The spot exchange rate is determined by the relative prices
of similar basket of goods
S($/£) = P($)/P(£) (2)
: The relative change in prices between countries over a period of time determines the
change in exchange rates
Consider inflation rates Today:
($/ )* P
In one year, P
[1+π(US)] = S
($/ ) * P
($/ )/ S
) = [1+π(US)] / [1+π(UK)]S
: current spot rate; S
: spot rate in one year
% change in FX rate (appreciation/depreciation of GBP; recall our “share”
U.S. has an expected inflation rate over the next 6 months of 3% per annum, U.K. has an expected
inflation rate over the next 6 months of 5% per annum and the current exchange rate is $2.04/£. What is the expected spot rate in 6 months?
($/ ) =
$2.04/£ * (1+3%*180/360) / (1+5%*180/360) = $2.02/£
Higher inflation in U.K.
Depreciation of the £; Appreciation of the $
exchange rate at the beginning of the year is
¥103/$. Suppose the CPI (consumer price index) is 110.00 in Japan and 105.00 in the U.S. at the beginning of
the year. Based on some econometric models, the expected CPI over one year is 112.20 in Japan and 108.15 in the U.S. (a) What is the expected inflation
rate over one year in Japan?
(b) Assuming that purchasing power parity holds, what would the exchange rate be at the end of the year (¥/$)?
(b)The expected inflation rate in the US = (108.15-105)/105 = 3%
The expected FX rate at the end of the year =
Exchange rate pass-through (Honda or BMW example)
The degree to which the prices of imported &
exported goods change as a result of exchange rate changes is termed
The price of Honda vehicle is ¥4,000,000 in Japan. The
current spot rate is ¥125.0/$. For the coming year, π(US)=3.0% and π(Japan)=1.0%.(a) What was the dollar price of a Honda vehicle at the beginning of the
(b) Assuming PPP, what is the expected spot rate at the end of the year?
(¥/$) = (¥125.0/$)*(1+1%)/(1+3%)
(USD depreciates or JPY appreciates, why?) (c) Assuming 100% pass through of FX rate changes, what would the USD price of a Honda be at
the end of the coming year?
¥4,000,000*(1+1%) = ¥4,040,000
(the USD price includes inflation and FX rate
changes) (d) Assuming 60% pass through of FX rate changes, what would the USD price of a Honda be at the end of the coming year?
New Honda Yen
price in one year = ¥4,000,000*(1+0.01) = ¥4,040,000; If FX rate didn't change, Honda USD price = 4,040,000/125.00 = 32,320 (base price)