Lectures 3+4 - Price levels and the exchange rate in the long run
16. Price Levels and Exchange Rates in the Long-Run
16.1 Long-Run Approach
Flexible Prices: In the long run, prices are considered perfectly flexible.
Increase in Money Supply (M↑): This leads to an increased demand for goods, which causes increasing price levels (P↑).
This results in the ratio of money to prices (M/P) returning to its original level.
Demand Relationships:
Demand for domestic goods relative to foreign goods decreases.
Demand for domestic currency decreases relative to foreign currency, resulting in an increase in the exchange rate (depreciation of domestic currency).
16.2 Models to Predict Exchange Rates
Short-Run vs Long-Run:
Short-run: An increase in M causes a change in exchange rates through asset demand for currencies (M → R → demand for financial assets → demand for currencies → exchange rate).
Long-run: Adjusts P mitigates initial exchange rate changes (M → P → demand for goods and currencies → exchange rate).
Key Approaches:
Law of One Price and Purchasing Power Parity (PPP) contribute to long-run models of exchange rates.
16.3 Key Concepts and Relationships
Purchasing Power Parity (PPP): Implies that the ratio of average prices across countries determines exchange rates.
If a basket of goods costs 100 EUR in the Eurozone and 200 CHF in Switzerland, the implied exchange rate under PPP is 1/2.
Fisher Effect: The relationship between nominal interest rates and inflation, stating that the expected nominal interest rate equals the real interest rate plus anticipated inflation.
16.4 Law of One Price
Definition: If free trade is costless, identical goods should sell for the same price across different countries.
Arbitrage Mechanism: When price differences exist, arbitrage occurs until prices adjust to equality.
16.5 Violation of Law of One Price
Reasons for Violation:
Tax Differences: Variations in taxation across countries affect pricing.
Transportation Costs: Increase the cost of goods thus leading to price variations.
Competition Forms: Different market structures across countries can lead to different price levels.
16.6 Purchasing Power Parity (PPP)
PPP Application: Applies to baskets of goods and services across countries.
Average Price Level: Average price levels (PNL for Netherlands, PCH for Switzerland) express relationship between currencies (EUR/CHF exchange rate).
16.7 Average Prices and Exchange Rates
Absolute vs Relative PPP:
Absolute PPP holds when exchange rates equal relative average prices.
Relative PPP holds if exchange rate changes correspond to changes in price levels.
16.8 Real Exchange Rate Approach
Definition: The real exchange rate reflects the rate of exchange for goods and services, factoring in relative price differences.
Determinants:
Nominal Exchange Rate
World Relative Demand: Increased relative demand for goods raises their value relative to others.
Relative Supply: Changes in the relative supply can also impact prices and exchange rates.
16.9 Interest Rate Differences and the Fisher Effect
Expected Changes in Real and Nominal Exchange Rates: Nominal rate changes relate to expected inflation and real depreciation rates.
Real Interest Rates: Measured in terms of output and encompassing the effects of inflation.
16.10 Real Interest Rates and Expectations
Real Interest Parity Condition: Real interest rates accounting for anticipated currency depreciation inform investment decisions and currency switching.
Conclusion on PPP: Empirical evidence may not support absolute PPP while relative PPP is more applicable in many scenarios.