Exchange Rates and Purchasing Power Concepts

Nominal Exchange Rate

  • Defined as the rate at which one currency can be exchanged for another.

  • Example: 1 US dollar (USD) = 10 Mexican pesos (MXN).

Price of Goods in Different Countries

  • Price of a Starbucks latte in the USA: $3

  • Price of a Starbucks latte in Mexico: 25 pesos

Calculating Price in Pesos

  • Importantly, convert the latte price in the USA into pesos:

    • $3 USD * 10 MXN/USD = 30 MXN

    • Thus, the price of a latte in the USA measured in pesos is 30 pesos.

Real Exchange Rate (ER)

  • Formula to calculate the real exchange rate: ER = \frac{E \times P}{P^*} where:

    • E = nominal exchange rate

    • P = price level in home country (CPI)

    • P* = price level in foreign country (CPI)

  • Calculate real exchange rate using the example given:

    • If P = 30 (price in pesos) and P* = 24 (price level in Mexico)

    • ER = \frac{30}{24} = 1.25

  • Interpretation:

    • A real exchange rate greater than 1 indicates that goods are more expensive in the home country (USA).

Importance of Overall Price Index (CPI)

  • Real exchange rates are generally calculated based on overall price indices rather than specific goods like lattes.

  • This is to understand how price levels are changing over time in different countries.

Monthly Calculation of Real Exchange Rate

  • Real exchange rates can be calculated on a monthly basis by:

    • Collecting nominal exchange rates for each month.

    • Collecting CPI values for each month for the countries of interest.

Rising Real Exchange Rate

  • An increasing real exchange rate indicates that goods and services in the home country are becoming more expensive.

Law of One Price and Purchasing Power Parity (PPP)

  • These concepts rely on several strong assumptions:

    1. No Government Restrictions: No taxes or tariffs affecting the trade of goods and services.

    2. Free Factor Movement: Factors of production like labor and capital can move freely between countries.

    3. No Transportation Costs: No costs associated with moving goods between countries.

  • Under these assumptions:

    • Prices of identical goods (e.g., Big Mac) should be the same between countries (e.g., USA and Japan).

    • The implied real exchange rate would be 1: ER = \frac{P{home}}{P{foreign}} = 1

  • This scenario supports the law of one price and the concept of purchasing power parity, suggesting a dollar has equal purchasing power around the world when these conditions hold.