Exchange Rates in the Long Run Under Flexible Prices

Exchange rates determine

value of one currency relative to another

Law of One Price (LOP)

In a frictionless market, identical goods should sell for the same price when expressed in a common currency.

Absolute Purchasing Power Parity (PPP)

In the absence of trade costs, the price level of a reference basket should be the same across countries

Real Exchange Rate (q)

if q>1, goods are more expensive in country 1

if q<1, goods are more expensive in country 2

Relative Purchasing Power Parity

Changes in the exchange rate must reflect inflation differences

If Japan experiences higher inflation than the U.S.

the yen should depreciate relative to the dollar

which is weaker RPPP or APPP?

RPPP → APPP implies RPPP but RPPP doesn't imply APPP

The Monetary Approach to Exchange Rates

Combines absolute PPP with the quantity theory of money

Quantity Theory of Money Implication:

increased M: P inc, depreciation

increased real output: inc nominal interest rate and appreciation

continuous money growth: higher inflation, depreciation

Why PPP Fails in Practice:

1. Trade Barriers & Nontradables: Import tariffs, quotas, and nontradable services (e.g., haircuts) prevent price equalization.

2. Imperfect Competition & Pricing to Market: Firms set different prices in different markets, leading to deviations from PPP.

The Balassa-Samuelson Effect

countries with higher productivity in tradable goods experience higher wages, which increases the cost of nontradable goods, leading to higher overall price levels.

This explains why richer countries tend to have higher price levels than poorer ones.

If investors expect the yen to appreciate in real terms,

apan must have a higher real interest rate than the U.S.

Higher expected appreciation leads to

higher real returns on that currency.

According to the monetary approach, what determines the price level in an economy?

The supply of money relative to demand, which depends on GDP and liquidity preferences

What happens to the exchange rate if a country increases its money supply?

The currency depreciates as prices rise.

What happens to a currency’s value when real output (GDP) increases?

The currency appreciates due to higher demand for money.

How do nontradables affect the real exchange rate?

Countries with higher productivity in tradables have higher prices for nontradables.

What happens when demand for a country’s goods increases?

Its currency appreciates due to increased demand.

How does expected inflation impact exchange rates?

Higher expected inflation leads to currency depreciation.

What does real interest rate parity suggest?

Real interest rates should be equal across countries when adjusted for exchange rate expectations.

How do interest rates affect exchange rate movements?

Higher domestic interest rates lead to currency appreciation, assuming no inflation changes.

What is the relationship between nominal and real exchange rates?

"Real = Nominal Adjusted for Prices"

• Nominal exchange rate → Just the market rate between currencies.

• Real exchange rate → Adjusts for differences in price levels (inflation).

• If real exchange rate rises, domestic goods become more expensive relative to foreign goods.