ECON 335: International Economy - Chapter 11 Notes

Chapter 11: Exchange Rates: The Monetary Approach in the Long Run

Introduction

  • The theory that will be developed links the exchange rate to price levels in each country in the long run, based on the theory of purchasing power.

  • Price levels are related to monetary conditions in each country.

  • Combining the monetary and purchasing power theories, a long-run theory known as the monetary approach to exchange rates will be developed.

Exchange Rates and Prices in the Long Run: Purchasing Power Parity and Goods Market Equilibrium

  • When applied to a single good, the equalization of prices across countries is referred to as the law of one price.

  • When applied to an entire basket of goods, it is called the theory of purchasing power parity (PPP).

  • Arbitrage can occur in international goods markets, similar to international financial markets. Therefore, the prices of goods in different countries, when expressed in a common currency, tend to equalize.

  • A simple theory is developed based on an idealized world of frictionless trade where transaction costs are neglected.

The Law of One Price

  • The law of one price (LOOP) states that in the absence of trade frictions and under free competition and price flexibility, identical goods sold in different locations must sell for the same price when expressed in a common currency.

  • For any good gg sold in two locations, the law of one price can be stated as:

    E{$/€} = \frac{P^g{US}}{P^g_{EUR}}

  • Where E_{$/€} is the exchange rate.

  • LOOP holds if and only if the expression equals 1.

The Law of One Price (cont.)

  • The equation for price equality can be rearranged to show that the exchange rate must equal the ratio of the goods’ prices expressed in the two currencies:

    E{$/€} = \frac{P^g{US}}{P^g_{EUR}}

Purchasing Power Parity

  • The principle of purchasing power parity (PPP) is the macroeconomic counterpart to the microeconomic law of one price (LOOP).

  • To express PPP algebraically, the relative price of two baskets of goods in each location can be computed:

    q{US/EUR} = \frac{E{$/€} P{EUR}}{P{US}}

Purchasing Power Parity (cont.)

  • PPP then holds if price levels in two countries are equal when expressed in a common currency.

  • This condition is called absolute PPP.

  • There is no arbitrage when the basket is the same price in both locations, i.e., when qUS/EUR=1q_{US/EUR} = 1.

The Real Exchange Rate

  • The U.S. real exchange rate q{US/EUR} = E{$/€} \frac{P{EUR}}{P{US}} indicates how many U.S. baskets are needed to purchase one European basket.

  • The exchange rate for currencies is a nominal concept.

  • The real exchange rate is a real concept and represents the relative price of the baskets.

The Real Exchange Rate (cont.)

  • If the real exchange rate rises (more Home goods are needed in exchange for Foreign goods), Home has experienced a real depreciation.

  • If the real exchange rate falls, Home has experienced a real appreciation.

  • The real exchange rate uses terminology similar to the nominal exchange rate.

Absolute PPP and the Real Exchange Rate

  • If the real exchange rate qUS/EURq_{US/EUR} is below 1, then Foreign goods are relatively cheap.

  • In this case, the Home currency is considered strong, the euro is weak, and the euro is said to be undervalued.

  • If the real exchange rate qUS/EURq_{US/EUR} is above 1, then Foreign goods are relatively expensive.

  • In this case, the Home currency is considered weak, the euro is strong, and the euro is said to be overvalued.

  • Purchasing power parity states that the real exchange rate is equal to 1.