Price Levels and the Exchange Rate in the Long Run

Behavior of exchange rates in the long run

allows for sufficient amount of time for prices of all goods and services to adjust to market conditions so that their markets and the money market are in equilibrium

goal of long run models

represents how market participants may form expectations about future exchange rates and how exchange rates tend to move over long periods

the law of one price

the same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important

who does the law of one price work

because if two places near each other had different prices everyone would go to the place with the cheaper prices and sell it at the expensive for a profit
- the cheaper place would have high demand but a shortage and prices would increase
- the more expensive place would have low demand but a surplus causing price to decrease
- prices adjust to one for the market

purchasing power parity (PPP)

the application of the law of one price across countries for all goods and services or for representative groups ("baskets") of goods and services

implies that the exchange rate is determined by levels of average prices

absolute PPP

exchange rates equal the level of relative average prices across countries

relative PPP

changes in exchange rates equal changes in prices (inflation) between two periods

relative PPP predicts that

the country with the higher inflation rate will see its currency depreciate by the amount of the differential
- holds better for high inflation differences

a change in the money supply results in

a change in the level of average prices

a change in the growth rate of the money supply results in

a change in the growth rate of prices (inflation)

a constant growth rate in the money supply results in a

persistent growth rate in prices (persistent inflation) at the same constant rate, when other factors are constant

inflation does not affect the

productive capacity of the economy and real income from production in the long run

inflation does affect

the nominal interest rates

fisher effect

a rise in the domestic inflation rate causes an equal rise in the interest rate on deposits of domestic currency in the long run, when other factors remain constant

monetary approach to exchange rates

the increase in nominal interest rates decreases the demand of real monetary assets

the money supply and prices are predicted to grow at rate (inflation + change in inflation)

and the domestic currency is predicted to depreciate at the same time

in the long run model without PPP and with stick prices

- increase in money supply lead to increases in the level of average prices
- no inflation is predicted to occur in the long run, but only during the transition to the long run equilibrium
- during the transition inflation causes the nominal interest rate to increase back to its long run value

expectations of higher domestic inflation in the long run model without PPP and with sticky prices

cause the expected return on foreign currency deposits to increase making the domestic currency depreciate before the transition period due to the fall in the nominal interest rate

in the monetary approach (with PPP)

the rate of inflation increases permanently when the growth rate of the money supply increases permanently
with persistent domestic inflation the monetary

approach also predicts an increase in the domestic nominal interest rate

expectations of higher domestic inflation in the monetary approach with PPP

cause the expected purchasing power of domestic currency to decrease relative to the expected purchasing power of foreign currency, thereby making the domestic currency depreciate

in the long run model without PPP

the level of average prices does not immediately adjust even if expectations of inflation adjust
CAUSES: the exchange rate to overshoot its long run value

in the monetary approach (with PPP)

the level of average prices adjusts with expectations of inflation causes the domestic currency to depreciate but with no overshooting

shortcomings of PPP

there is little empirical support for absolute purchasing power parity
- they actually differ substantially across countries
- relative PPP is more consistent with data but it also performs poorly to predict exchange rates

currency is overvalued if it

takes more FX to buy than predicted by PPP
- when ER FX/$ is above the PPP ER FX/$ the dollar is overvalued
- when ER $/FX is above the PPP ER $/FX the FX is overvalued

currency is undervalued if it

takes less FX to buy than predicted by PPP
- when ER FX/$ is below the PPP FX/$ , the $ is undervalued
-when ER $/FX is below the PPP ER $/FX the FX is undervalued

Reasons why PPP may not be accurate

the law of one price may not hold because of:
1. Trade barriers and non tradable products
2. Imperfect competition
3. Differences in measures of average prices for baskets of goods and services

trade barriers and nontradable products

- transport costs and governmental trade restrictions make trade expensive and in some cases create nontradable goods or services
- services are often not tradable: services are generally offered within a limited geographic
- the greater the transport costs, the greater the range over which the exchange rate can deviate from its PPP value
- one price need not hold in two markets

Imperfect competition

may result in price discrimination: "pricing to market"
- a firm sells the same product for different prices in different markets to maximize profits, based on expectations about what consumers are willing pay
- one price need not hold in two markets

differences in the measure of average prices for goods and services

- levels of average prices differ across countries because of differences in how representative groups (" baskets") of goods and services are measured
- because measures of groups of goods and services are different, the measure of their average prices need not be the same
- one price need not hold in two markets

because of shortcomings in PPP economists have

tried to generalize the monetary approach to PPP to make a better theory through the real exchange rate

the real exchange rate is the

rate of exchange for goods and services across countries
- the relative value/ price/ cost of goods and services across countries

according to the real exchange rates approach what are the effects on the nominal exchange rate?

when only monetary factors change and PPP holds, we have the same predictions as before
- no changes in real exchange rate occurs

when factors influencing real output change, the real exchange rate changes
- increase in relative demand of domestic products lead to a real appreciation, appreciating the dollar
- increase in relative supply of domestic products lead to a real depreciation, depreciating the dollar

when economic changes are influences only by monetary factors and when the assumptions of PPP hold

nominal exchange rates are determined by PPP

when economic changes are caused by factors that affect real output, exchange rates are not determined by PPP only

but are also influenced by the real exchange rate

real interest rates are measured in terms of real output

- the quantity of goods and services that savers can purchase when their assets pay interest
- the quantity of goods ad services that borrowers cannot purchase when they must pay interest on their loans