The Price Level & Exchange Rate in the Long Run Chapter 15

What Makes Currencies Appreciate or Depreciate? Foreign and Domestic Money Growth (mostly)

What is the Benchmark Exchange Rate What is the Benchmark Exchange Rate? Can One Tell if a Currency is Overvalued? One Benchmark is Purchasing Power Parity

Law of One Price & Purchasing Power Parity Law of one price - compare individual prices across countries. Purchasing Power Parity – compare average prices across countries.

Law of One Price After converting with exchange rates, prices should be the same across countries PUS = E$/€(PG) PUS - the US price of a good in $ PG - the German price of a good in € E$/€ - the $ value of the €

Logic of the “Law” of One Price In a well functioning market buyers should buy from low price sellers and avoid high price sellers This should tend to make prices converge

Law of One Price Rationale Rationale is based on arbitrage, suppose the price is higher in the US, PUS > E$/€(PG) What will arbitrageurs do? How does that change prices?

Purchasing Power Parity Purchasing power parity (PPP) predicts that in LR, E adjusts to equalize purchasing power & price averages across countries PUS = E$/€ PG PUS - US price index in $ PG - German price index in €, E$/€ - $ value of €.

Purchasing Power Parity & LR E The PPP prediction of LR E is E$/€ = PUS /PG. Alternatively, suppose E$/€ > PUS /PG Whose goods are more expensive? What will arbitrageurs do? What are the implications for currency markets?

April 2002

McCurrencies: 2002 US Price = $2.49 P* E EP* e E/e   P* E EP* e E/e Australia 3.00 .54 1.62 .83 .65 Russia 39 .032 1.25 .064 .50 Japan 262 .0077 2.01 .0095 .81 Euroland 2.67 .89 2.37 .93 .95

McCurrencies: Where’s the beef? US price of Big Mac was P = $2.49 In LDC’s prices are lower than US prices currencies are undervalued against the $? In developed countries prices also tend to be lower

April 2003

McCurrencies: 2003 US Price = $2.71 P* E EP* e E/e   P* E EP* e E/e Australia 3.00 .62 1.67 .90 .69 Russia 41 .032 1.32 .066 .49 Japan 262 .0083 2.18 .0103 .81 Euroland 2.71 1.10 2.98 1.00 1.10

Law of One Price Violations In the real world, the law of one price is frequently violated because Transportation costs inhibit arbitrage Tariffs & quotas inhibit arbitrage Monopoly power permits price discrimination Nontradables - some goods are not traded

Predicting E Using PPP PPP predictions of E, like E$/€ = P$/PG, are generally poor (SR) predictors of E Relative PPP, % in E = difference in inflation, does a little better, but is still not great PPP is good for predicting the effects of monetary disturbances & not so good for predicting the effects of real disturbances

Figure 15-3 The Dollar/DM Exchange Rate and Relative U. S Figure 15-3 The Dollar/DM Exchange Rate and Relative U.S./German Price Levels, 1964-2000

Monetary Disturbances & E To make quantitative predictions rely on P = M/L E$/£ = PUS/PUK A 5%  in M results in a 5%  in both P & E

Law of One Price & Development

The Law of One Price & Development Prices are generally higher in more developed countries Developed countries have high productivity in manufacturing (tradables) High manufacturing productivity drives up wages & the cost of nontradables like services & real-estate

U.S. and Thailand: Wages & Jeans Price of Jeans in Thailand = 400 Baht a pair = PT Price of Jeans in U.S. = $10 a pair = Pus E$/baht = .025 (Ebaht/$ = 40) $ price of Thailand Jeans = $10 = E$/baht (PT) Is Baht overvalued? No PT/Pus = Ebaht/$ = 40

Why Aren’t Jeans Cheaper in Thailand Wage of stitcher in Thailand = 40 Baht/hour = $1/hour Wage of stitcher in U.S. = $6/hour Productivity in Thailand = 1 pair/hour Productivity in U.S. = 6 pair/hour

Why Aren’t Jeans Cheaper in Thailand? Stitching cost in Thailand = $1 per pair Stitching cost in U.S. = $1 per pair “real” wage in Thailand = 1/10 pair per hour “real” wage in U.S. = 6/10 pair per hour

Do Low Wages in Thailand Prevent U.S. Inflation? If the U.S. increases its money supply Won’t US Jeans makers who raise prices be unable to compete with cheap Thailand jeans? What about Ecuador?

Do Low Wages in Thailand Prevent U.S. Inflation?

Do Low Wages in Thailand Prevent U.S. Inflation? U.S. money supply increases to 1200 Pus = $12 a pair E$/baht = .03 (Ebaht/$ = 33) PT = $12 a pair

U.S. and Thailand: Wages & Haircuts Productivity in U.S. = 2 haircuts/hour Productivity in Thailand = 2 haircuts/hour Labor cost in U.S. = $3/haircut Labor cost in Thailand = $0.50/haircut

Why is the U.S. Cost of Living Higher? Productivity in U.S. is high in manufacturing and agriculture >> wages are high overall >> services are expensive Productivity in Thailand is low in manufacturing and agriculture >> wages are low overall >> services are cheap

Why is the U.S. Cost of Living Higher? If services were tradable U.S. would import its services from Thailand. Instead expensive domestic services give U.S. a higher cost of living.

Increase in M versus M/M M is the money supply M/M is the monetary growth rate

Increase in M versus M/M A one time 5%  in M implies a one time 5%  in P & a one time 5%  in E An ongoing 5%  in M growth implies an ongoing 5%  in inflation & an ongoing 5%  the appreciation rate of the foreign currency

Inflation and Exchange Rates U.S. inflation = 2.8% per year throughout the 90’s (27% cumulative price increase) Germany 2.2% per year 21% cumulative Japan 1.1% per year 10% cumulative These are the leading members of the “stable price club”

Inflation and Exchange Rates per year cumulative Chile 10% 163% India 9% 143% Indonesia 13% 245% Israel 10% 165% Kenya 15% 320% Mexico 18% 453% South Africa 9% 136% Tanzania 20% 575%

Inflation and Exchange Rates Typical members of the “chronic inflation club” Av. inflation 13% per year (250% cumulative) (Excludes “hyperinflation” cases like Ecuador: inflation at 10% per month recently)

Inflation and Exchange Rates Why do they have double digit inflation? Double digit money growth money growth inflation SP club 4% 2% CI club 21% 13%

Inflation and Exchange Rates Increase supply of pesos faster than the economy can increase the supply of goods and the peso buys less goods (inflation) Increase the supply of pesos faster than the supply of dollars or yen increases and the peso buys less dollars and yen (depreciation)

Inflation and Exchange Rates money growth inflation depreciation SP club 4% 2% - CI club 21% 13% 12%  71% over 10 years

Inflation and Exchange Rates Chronic depreciation is a manifestation of chronic inflation Depreciation keeps the goods of the CI club competitive in world markets

Inflation and Exchange Rates Can members of the chronic inflation club join the stable price club? Yes. They can control the growth of their money supply. Will their exchange rate be stable if they do? Not Really. Stable price currencies fluctuate violently, but the chronic depreciation will end.

Figure 15-3 The Dollar/DM Exchange Rate and Relative U. S Figure 15-3 The Dollar/DM Exchange Rate and Relative U.S./German Price Levels, 1964-2000

Inflation and Exchange Rates Argentina money inflation depreciation growth (cumulative) 1987-1991 201% 223% 99.99% 1992-2000 4% 4% 0.0%

Fixed Exchange Rates How was the Argentine exchange rate fixed to the dollar? The Argentine Central bank intervened in the foreign exchange market It bought Pesos when demand was weak (demand for dollars was strong) and sold pesos when demand was strong (demand for dollars was weak).

Interest Rates & Monetary Disturbances R = r + e (Fisher equation) R is the nominal & r is the real interest rate, e is expected inflation r is unchanged by monetary disturbances A one time 5%  in M implies no change in e & R An ongoing 5%  in M growth implies an  in e & R of 5% (Fischer effect)

Liquidity Effects versus Fisher Effects Suppose M/M  In the SR, M/P , R & r  (Liquidity effect) In the LR, inflationary expectations  R  above its initial value (Fisher effect) r returns to its initial value

Interest Rates and Inflation During the 1970's M/M , causing  , & R followed w/ a lag In late 1979, Volker took over at the Fed & M/M  R initially  R ultimately 

Inflation and Interest Rates 1970 - 2000

Inflation and Interest Rates 1970 - 2000

What Effect do Increases and Decreases in the Rate of Money Growth Have on: Interest Rate? Prices? Exchange Rates?

Figure 15-1 Long-Run Time Paths of Economic Variables after a Figure 15-1 Long-Run Time Paths of Economic Variables after a Permanent Increase in the Growth Rate of the Money Supply (a) U.S. money supply, MUS Time (b) Dollar interest rate, R$ Time Slope =  +  t0 R$2 = R$1 +  t0 MUS, t0 R$1 Slope =  (c) U.S. price level, PUS Time (d) Dollar/euro exchange rate, E$/€ Time Slope =  +  Slope =  +  t0 t0 Slope =  Slope = 