Chapter 31 -- Carlos Pitta

# P price of us big mac in dollars p price of japanese

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P = price of US Big Mac (in dollars) P* = price of Japanese Big Mac (in yen) e = exchange rate, yen per dollar According to PPP, e x P = P* price of Japanese Big Mac, in yen Solve for e : P* P e = price of US Big Mac, in yen 0

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CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 35 PPP and Its Implications PPP implies that the nominal exchange rate between two countries should equal the ratio of price levels. If the two countries have different inflation rates, then e will change over time: If inflation is higher in Mexico than in the U.S., then P* rises faster than P , so e rises – the dollar appreciates against the peso. If inflation is higher in the U.S. than in Japan, then P rises faster than P* , so e falls – the dollar depreciates against the yen. P* P e = 0
CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 36 Limitations of PPP Theory Two reasons why exchange rates do not always adjust to equalize prices across countries: Many goods cannot easily be traded Examples: haircuts, going to the movies Price differences on such goods cannot be arbitraged away Foreign, domestic goods not perfect substitutes E.g., some U.S. consumers prefer Toyotas over Chevys, or vice versa Price differences reflect taste differences 0

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CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 37 Limitations of PPP Theory Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends. For example, PPP implies: the greater a country’s inflation rate, the faster its currency should depreciate (relative to a low-inflation country like the US). The data support this prediction… 0
0.1 1.0 10.0 100.0 1,000.0 10,000.0 0.1 1.0 10.0 100.0 1,000.0 Inflation & Depreciation in a Cross-Section Inflation & Depreciation in a Cross-Section of 31 Countries of 31 Countries Avg annual CPI inflation 1993-2003 (log scale) Avg annual depreciation relative to US dollar 1993-2003 (log scale) Ukraine Brazil Japan Canada Mexico Argentina Romania Kenya 0

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Think! Think!     Chapter review questions Chapter review questions 1. Which of the following statements about a country with a trade deficit is not true ? A. exports < imports B. net capital outflow < 0 C. investment < saving D. Y < C + I + G 2. A Ford Escape SUV sells for \$24,000 in the U.S. and 720,000 rubles in Russia. If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)? 39 0
Think! Think!     Answers Answers 1. Which of the following statements about a country with a trade deficit is not true ? C. investment < saving is not true. A trade deficit means NX < 0. Since NX = S I , a trade deficit implies I > S . 40 0

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Think! Think!     Answers Answers 2. A Ford Escape SUV sells for \$24,000 in the U.S. and 720,000 rubles in Russia. If purchasing-power parity holds, what is the nominal exchange rate (rubles per dollar)? P* = 720,000 rubles P = \$24,000 e = P* / P = 720000/24000 = 30 rubles per dollar 41 0
CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 42 CHAPTER SUMMARY Net exports equal exports minus imports.

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