Quick Review: A Simple Model of Long Run Exchange Rates Roberto Chang February 2013.

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Presentation transcript:

Quick Review: A Simple Model of Long Run Exchange Rates Roberto Chang February 2013

Reminder… No class on Monday! Next week reading : chapter 4 of FT

Purchasing Power Parity PPP is a long run relation between exchange rates and price levels Absolute PPP: P US = E $/€ *P EUR In changes  Relative PPP: π US = (∆ E $/€ / E $/€ ) + π EUR

So… Absolute PPP implies E $/€ = P US /P EUR while relative PPP gives ∆ E $/€ / E $/€ = π US – π EUR ==> To derive predictions for the exchange rate, we need to understand the determinants of price levels.

A Simple Theory of the Price Level Supply and Demand for Money: M US = M d US = LP US Y US So P US = M US /LY US And π US = µ US – g US

Long Run Exchange Rates From Absolute PPP, now, E $/€ = P US /P EUR = (M US /LY US )/(M EU /L * Y EU ), or E $/€ = constant * (M US / M EU )/(Y US / Y EU ) In changes, ∆ E $/€ / E $/€ = π US – π EUR = µ US – g US - (µ EU – g EU )