1 Chapter 5 Price Levels and the Exchange Rate in the Long Run 5-2 Preview • gradual build-up of model continues, by extending it in two directions : 1. deeper analysis of linkages between money, inflation, interest rates, and exchange rates 2. factors other than money supply & demand; e.g. demand shifts in markets for goods and services Þ model of long-run exchange rate behavior; framework used by actors in asset markets to forecast future exchange rates = to form expectations
2 5-3 Structure of Chapter • the theory of PPP • explains movements between two countries ’ currencies by changes in the countries' price levels • empirical evidence on PPP • why PPP may fail to give accurate long-run prediction • theory must D to account for shifts in output markets • 'extended PPP theory': predictions? 5-4 5.1. The law of one price (p. 136) • "in competitive markets free of transportation costs and official barriers to trade (such as tariffs), identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency"
3 5-5 5.1. The law of one price • example: E USD/UKP = 1.45 USD/UKP P US = 45 USD per sweater P UK = 30 UKP per sweater (in USD:)= 30 UKP/sweater * 1.45 USD/UKP = 43.50USD/sweater => P US > P UK * E USD/UKP => sweaters are cheaper in UK => buy sweaters in UK and sell them in US => P UK - P US ¯ until : P i US = P i UK * E USD/UKP • law of one price = link between domestic prices and exchange rates E USD/EUR = P i US / P i EU 5-6 The Economist ’ s Big Mac Index • what is? • test of law of one price • light-hearted guide to whether currencies are over/undervalued • calculation? see next slide
4 5-7 The Economist ’ s Big Max Index: calculation Source: Economist.com , July 28, 2011 5-8 Law of One Price for Hamburgers?
5 5-9 • 1998: Big Mac index predicted fall of euro! April 1999: "euro's 'correct' PPP exchange rate close to parity with the dollar – precisely where it moved early this year ” • February 2007 • Icelandic krona most overvalued (+131%) • Chinese yuan most undervalued (-56%) The Economist ’ s Big Mac Index: track record 5-10 • May 2004 • "perhaps the most interesting finding is that all emerging- market currencies are undervalued against the dollar. The Chinese yuan , on which much ink has been spilled in recent months, looks 57% too cheap ". • ! "That a Big Mac is cheap in China does not in fact prove that the yuan is being held massively below its fair value , as many American politicians claim. It is quite natural for average prices to be lower in poorer countries and therefore for their currencies to appear cheap". • Parsley and Wei (2004): non-traded inputs account for between 55% and 64% of the price of a Big Mac - cf. B-S effect in textbook – The Economist ’ s Big Mac Index: a warning
6 5-11 The Economist ’ s Big Mac Index: most recent results • cheap currencies have narrowed the valuation gap against the dollar • euro 8.4% undervalued vs. 16% in June Source: “The Mac strikes back”, The Economist , January 20, 2018 5-12 The Economist ’ s Big Mac Index:
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