Price Levels and the Exchange Rate in the Long Run

Chapter 16 International Economics

Udayan Roy

Overview

• Long-run analysis– Real variables– Nominal variables

• Flexible exchange rates– We will study fixed exchange rates in Chapter 18

The Real Exchange Rate

• We discussed exchange rates in Chapter 14– Example: €1 = $1.50

• Those exchange rates are nominal exchange rates

• Now we’ll discuss real exchange rates

The Real Exchange Rate• Let us consider the price of an iPhone in US and

Europe:– In US, it is PUS = $200– In Europe, it is PE = €150– The value of the euro is E = 2 dollars per euro– So, Europe’s price in dollars is E × PE = $300– So, each iPhone in Europe costs as much as 1.5

iPhones in US– E × PE / PUS = 1.5– This is the real dollar/euro Exchange Rate for iPhones

The Real Exchange Rate

• In general, the real exchange rate is a broad summary measure of the prices of one country’s goods and services relative to another’s.– The real dollar/euro exchange

rate is the number of US reference commodity baskets—not just iPhones—that one European reference commodity basket is worth

– Equation (16-6) in KOM9e

US

E

P

PEq

/$

/$

E$/€ is the nominal exchange rate, the price of one euro in dollarsPE is the overall price level in Europe, such as the consumer price indexPUS is the overall price level in the United States

Depreciation and Appreciation

Euro Dollar Europe’s exports America’s exports

q$/€↑ Real Appreciation

Real Depreciation

More expensive Less expensive

q$/€↓ Real Depreciation

Real Appreciation

Less expensive More expensive

The Real Exchange Rate

• Example: If the European reference commodity basket costs €100, the U.S. basket costs $120, and the nominal exchange rate is $1.20 per euro, then the real dollar/euro exchange rate (q$/€) is 1 U.S. basket per European basket.

• Real depreciation of the dollar against the euro– A rise in the real dollar/euro exchange rate (q$/€↑)

• is a fall in the purchasing power of a dollar within Europe’s borders relative to its purchasing power within the United States

• Or alternatively, a fall in the purchasing power of America’s products in general over Europe’s.

• Real appreciation of the dollar against the euro is the opposite of a real depreciation: a fall in q$/€.

Real Depreciation and Appreciation

Absolute PPP

• A very simple theory of the real exchange rate is called Absolute Purchasing Power Parity

• It says that:q = 1

• Why?

Law of One Price

• Going back for a second to the iPhone example, one can argue that PUS, the dollar price in the US, ought to be equal to E × PE, the dollar price in Europe. That is,

• E × PE = PUS.

• In general, E$/€ x PE = PUS.

• Therefore, q$/€ = (E$/€ x PE)/PUS = 1.• This is the Law of One Price or Absolute

Purchasing Power Parity.

Absolute and Relative PPP

• Chapter 16 of the textbook (KOM9e) uses Absolute PPP in the first part of the chapter and Relative PPP in the second part– Absolute PPP: q = 1– Relative PPP: q = a constant, not necessarily 1

• Although the results in the following slides have been proved for APPP, they are also true under RPPP

Prices and the Exchange Rate

• Relative PPP says: • Therefore, • Therefore, as is constant, the faster domestic

prices (P) grow, the faster the foreign currency’s exchange value (E) will grow

• And, the faster foreign prices (P*) grow, the slower the foreign currency’s exchange value (E) will grow

Prices and the Exchange Rate

• In general, – where Eg is the growth rate of E. This is the

appreciation rate of the foreign currency– π* is the foreign inflation rate, and– π is the domestic inflation rate

• Example: If US inflation is 3% a year and Canadian inflation is 1% a year, then the exchange value of the Canadian dollar, measured in US dollars, will increase 2% a year

Equation (16-2) of the textbook, KOM9e

The Interest Rate

• We have seen in Chapter 15 that the interest parity equation is

• The second term on the right-hand side is the expected appreciation rate of the foreign currency

• Assumption: The expected appreciation rate is assumed to be equal to the actual appreciation rate (Eg), in the long run

The Interest Rate

• Therefore, • We saw two slides earlier that • Therefore,

• Assumption: The foreign interest rate (R*) and the foreign inflation rate (π*) will be assumed to be exogenous constants

Equation (16-5) of the textbook, KOM9e

The Interest Rate: Fisher Effect

• As the foreign interest rate (R*) and the foreign inflation rate (π*) are assumed to be exogenous constants, any change in the domestic inflation rate will cause an equal change (both in magnitude and direction) in the domestic nominal interest rate

• This is called the Fisher Effect

Real Interest Rate Parity

• implies

• R is the nominal interest rate. – It tells you how fast the dollar value of your wealth is

increasing • R – π is the real (or, inflation-adjusted) interest rate. – It tells you how fast the purchasing power of your wealth

is increasing• We now see that in the long run equilibrium, real

interest rates must be equal in all countries

The Interest Rate

• Assumption: The domestic inflation rate (π) is constant in the long run equilibrium

• Then must also be constant in the long run equilibrium– We will now use this constancy of R to get a

theory of long run inflation

Output

• The real GNP produced when all resources are fully utilized is known by various names:– Long-run GNP– Natural GNP– Full-employment GNP– Potential GNP(Yf)

• Assumption: In the long run, the economy makes full use of all its resources

• Therefore, in long-run equilibrium, Y = Yf.

Output

• The full-employment output, Yf, is assumed to be exogenous

• Y = Yf is what we call a solution because it expresses an endogenous variable entirely in terms of exogenous variables

Inflation

• We have seen in Chapter 15 that equilibrium in the money market implies

• Moreover, • Simplifying a bit, • Therefore, in equilibrium, • Therefore,

Inflation

• Therefore, in the long-run, • We saw three slides back that R is constant in

the long run equilibrium. Moreover, L0 is an exogenous constant

• Therefore, the faster the money supply (Ms) grows, the faster the price level (P) will grow

• And, the faster potential GDP (Yf) grows, the slower the price level (P) will grow

Inflation

• In general, – Note that this is a solution because it expresses an

endogenous variable, π, entirely in terms of exogenous variables

• For example, if the Federal Reserve expands US money supply at the rate of 5% a year and if the US economy’s potential GDP increases at the rate of 3% a year, then, in the long run, the US inflation rate will be 2% a year.

The Interest Rate, again

• So far, we have shown that – (interest parity), – , and

• Therefore, the domestic nominal interest rate in the long run is , a constant– Note that this is a solution because it expresses an

endogenous variable, R, entirely in terms of exogenous variables

The Price Level

• A few slides back, we saw that in the long run the domestic price level is

• Moreover, we just saw that • Therefore, in the long run, the domestic price

level is

Appreciation Rate of the Foreign Currency

• We saw earlier that – the foreign currency appreciates at the rate , and – the inflation rate is ,

• Therefore, – Note that this is a solution because it expresses an

endogenous variable, Eg, entirely in terms of exogenous variables

The Exchange Rate

• Recall that under relative purchasing power parity, we have , which implies

• We have also seen two slides back that • Therefore,

Summary: Long-Run, Flexible Exchange Rates

• q = , relative PPP• Y = Yf

The crucial point to note about these expressions is that the variables on the right-hand sides of these equations are all exogenous. As exogenous variables are ‘mystery variables’ about which our theory has nothing to say, the equations on this slide say all that our theory can say about the endogenous variables on the left-hand sides of these equations.

Summary: Long-Run, Flexible Exchange Rates

• q = , relative PPP• Y = Yf

Keep in mind that we are talking about the long run here. So, these equations show us the long run effects of permanent changes in the exogenous variables on the equations’ right-hand sides.

Summary: Long-Run, Flexible Exchange Rates

• q = , relative PPP• Y = Yf

The first two variables are real variables: they can be measured even in barter (or, non-monetary) economies. The remaining variables are nominal variables: they make sense only on monetary economies.

Note that the money supply (Ms) has no effect on real variables. This is an instance of monetary neutrality in the long run.

Summary: Long-Run, Flexible Exchange Rates

• q = , relative PPP• Y = Yf

Flashback to Ch. 15 of the textbook (KOM9e):

“A change in the supply of money has no effect on the long-run values of the interest rate or real output.” (p. 369)

“A permanent increase in the money supply causes a proportional increasein the price level’s long-run value. In particular, if the economy is initially at full employment, a permanent increase in the money supply eventually will be followed by a proportional increase in the price level.” (p. 370)

RELATIVE PURCHASING POWER PARITY: A LONG-RUN THEORY OF THE REAL EXCHANGE RATE

We will return to this after discussing Chapter 17

We will return to this after discussing Chapter 17

Absolute PPP: logical, but not factual

• Despite the logical appeal of the Law of One Price or Absolute Purchasing Power Parity, available data suggests that it is not true

• This is why Relative Purchasing Power Parity is a more realistic alternative

Law of One Price for Hamburgers?

Equilibrium in the Goods Market

• Recall the following from Ch. 17:– , aggregate demand

– In goods market equilibrium, Y = D• Therefore,

TYCAqCACAGITYCCY mqy 00

TCAYCAqCACAGITCYCCY mmqyy 00

qCACAGITCACYCACCY qmymy 00

qCACAGITCACCYCACY qmymy 00

qCACAGITCACCYCAC qmymy 001

As Y = Yf in the long run, we now have , the long-run value of the real exchange rate!

qCACAGITCACCYCAC qmymy 001

q

mymy

CA

CAGICTCACYCACq 001

q

myf

my

CA

CAGICTCACYCACq 001

Real Exchange Rate in the Long Run

• It follows that:– Full-employment output (Yf) has a direct effect on

the real exchange rate (q)– Taxes (T) have a direct effect too– C0 + I + G + CA0 and CAq have inverse effects on the

real exchange rate (q)

q

myf

my

CA

CAGICTCACYCACq 001

When the supply of domestic goods increases, they will be cheaper relative to foreign goods. So, Yf↑ causes q↑.

When the demand for domestic goods increases, they will be more expensive relative to foreign goods, causing q↓.

Exercises

• How is the real exchange rate affected in the long run by a permanent increase in: – fiscal stimulus?– money supply?– foreigners’ preference for domestic products?– tariffs on imported goods?– foreign/domestic income and household wealth?

q

myf

my

CA

CAGICTCACYCACq 001

BONUS TOPIC: THE CURRENT ACCOUNT

The balance on a country’s current account (CA) is roughly its net exportsWhat does CA depend on in the long run?

We will return to this after discussing Chapter 17

The Current Account

• Recall the following from Ch. 17:– the goods market is in equilibrium when – Therefore, – and 0 < < 1– in the long run– C0, Cy, I, G, T, and Yf are exogenous

• So,

The Current Account

• As 0 < < 1, it follows that • It follows that in the long run, CA is – directly related with Yf and T, and – inversely related with C0, I and G

• The key things are domestic supply and demand. When domestic supply increases or domestic demand decreases, net exports increases.

CA

Yf, T +

C0, I, G −

The Current Account

• Contractionary fiscal policy or “fiscal austerity” (T↑ or G↓) is a way to raise a country’s net exports (CA↑)

• A fall in consumer wealth—caused by, say, a real estate crash or a stock market crash—reduces C0 and therefore leads to an increase in CA!

• Monetary policy has no effect• Tariffs on imports have no effect!

CA

Yf, T +

C0, I, G −

The Long Run and Monetary Neutrality

• The macroeconomic analysis of the long run is characterized by the concept of monetary neutrality

• That is, monetary arrangements and monetary policy have no effect on the behavior of real variables

• Therefore, the predictions summarized by the table on this slide are true for both the flexible exchange rate system of this chapter and the fixed exchange rate system of Chapter 18

CA

Yf, T +

C0, I, G −