Price levels and the exchange rate in the long run

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

Purchasing power parity

Application of the law of one price across countries for all goods and services, or for “baskets” of goods and services

What does the PPP imply about the exchange rate?

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

Rearrange the PPP equation to give: E(us$/C$)=Pus/canada

Absolute PPP

• Exchange rates equals the levels the level of relative average prices across countries
• Currencies of two countries have the same purchasing power
• E$/£=Pus/Puk

Relative PPP

Changes in the exchange rates equals the changes in prices between two periods

Monetary approach to exchange rates

Uses monetary factors to predict how the exchange rate adjusts in the long run, based on the absolute version of PPP

Monetary approach to exchange rates

The exchange rate is determined in the LR by prices, which are determined by relative supply and demand of real monetary assets in money markets across countries

What does a permanent increase in domestic money supply do? (Monetary approach to exchange rates)

• Causes a proportional increase in the domestic price level (inflation)
• Causing a proportional depreciation in domestic currency
• Same prediction as LR model without PPP

What does an increase in domestic interest rates do? (Monetary approach to exchange rates)

• Decreases the demand of real monetary assets
• Increases domestic prices
• Causes a depreciation of domestic currency (through PPP)

What does an increase in domestic level of production and income do? (Monetary approach to exchange rates)

• Increases domestic demand for real monetary assets (people can purchase more goods and services with more income)
• Decreases the level of domestic prices
• Causing a proportional appreciation of currency (Through PPP)

Monetary approach to exchange rates - What does a change in the growth rate of money supply do?

A change in the growth rate of the money supply results in a change in the growth rate of prices (inflation)

The Fisher effect

The relationship between nominal interest rates and inflation

An increase in domestic inflation rate caused equal increase in IR on deposits of domestic currency in the LR

The role of inflation and expectations in the LR without PPP

Expectations of higher domestic inflation cause the expected return on foreign currency deposits to increase, making the domestic currency depreciate

The role of inflation and expectations in the LR with PPP

Expectations of increasing domestic inflation 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

Level of average prices in the long-run model without PPP

Level of average prices does not immediately adjust even if expectation of inflation adjusts. This causes the exchange rate yo overshoot (domestic currency to depreciate more than) its LR value

Level of average prices in the long-run model in the monetary approach (with PPP)

Level of average prices adjust with expectations of inflation. Domestic currency depreciates but with no overshooting

The real exchange rate

The rate of exchange for goods and services across countries

The real exchange rate with a real appreciation of the value of US products

A real appreciation of the value of US products means an increase in dollars purchasing power of EU products relative to a dollar’s purchasing power of US products. US goods become more expensive and more valuable to relative to EU goods

What influences the real exchange rate?

A change in relative demand and supply

An increase in the relative demand of US products on the real exchange rate

Increase in relative demand of US products causes the value (price) of US goods relative to the value (price) of foreign goods to increase. Which causes an appreciation of value of US goods

What does an appreciation of the value of US goods cause?

Makes US exports more expensive and imports to the US less expensive (A decrease if the quantity demand of US products)

An increase in the relative supply of US products on the real exchange rate

Caused by an increase in US productivity which causes the price/cost to decrease. This leads to a depreciation of the value of US goods

What does a depreciation of the value of US goods cause?

US exports become less expensive whereas imports become more expensive

Increase in relative demand on domestic products- the real exchange rate

An increase in the relative demand on domestic products leads to a real appreciation