Price Levels & the Exchange Rate in the Long Run Demand shifts in markets for goods and serviceshave sustained effects on exchange rates. interest rateIn the long run, national price levels play a key role in determining interest rate the relative prices at which countries products are traded.

Purchasing Power Parity (PPP) 1.PPP explains exchange movements by changes in countries price levels 2.PPP failed to give accurate long-run predictions 3.PPP can be modified to account for supply and demand shifts in countries output markets 4.Relationship of PPP, money, output market, interest rate

The Law of One Price Is it different from absolute PPP?Is it different from absolute PPP?Is it different from absolute PPP?Is it different from absolute PPP?

Purchasing Power Parity PPP: the exchange rate between two countries currencies equals the ratio of the countries price levels. Chinese versionChinese version :Chinese versionChinese version

The relationship between PPP & the law of one price individual generalThe law of one price applies to individual commodities, while PPP applies to the general price level, which is a composite of the prices of all the commodities that enter into the reference basket.

Absolute PPP & Relative PPP Development of the equations:Development of the equations:Development of the equations:Development of the equations: Relative PPP:changesRelative PPP:changes Absolute PPP:levelsAbsolute PPP:levels

Requirements Absolute PPP: international standardized basket of commodities Relative PPP: inflationary differences (differ in coverage and composition) Relative PPP: approximate percentage changes

a long-run exchange rate model based on PPP the monetary approach to the exchange rate how exchange rates and monetary factors interact in the long run long rundoes not allow for the price rigidities the monetary approach proceeds as if prices can adjust right away to maintain full employment as well as PPP.

monetary approach monetary approach Fundamental equation of the monetary approach monetary approach Money supply Money demand 3 variables: money supply interest rate output level

Conclusion The exchange rate, which is the relative price of (Country A & B) money, is fully determined in the long run by the relative supplies of those monies and the relative real demand for them.

Interest Rate Parity still hold

The Fisher Effect The Fisher Effect 1.a rise in a countrys expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer. 2.purely monetary developments should have no effect on an economys relative prices

Paradoxical monetary approach prediction a currency depreciates when its interest rate? expected home inflation rises relative to foreign domestic price stickiness in the short run

money supply interest rise Reduce money demand Price level jumps to reduce M s exchange rate jumps

Empirical evidence on PPP & the Law of one price (P.408) 1.transport costs 2.government regulations 3.product differentiation. 4.McDonalds some power to tailor prices to the local market (wages of service people…)

Explaining the problems with PPP 1.transportation costs + trade barrier 2.monopolistic/oligopolistic practices 3.inflation data + commodity baskets

Trade barriers & nontradables the cost of producing some goods and services that they can never be traded internationally at a profit. haircut, routine medical treatment, aerobic dance instruction, housing services and the output of the construction industry

Departures from free competition when a single firm sells a commodity for different prices in different markets.

International differences in price level measurement Norwegian consumes more reindeer… Japanese consumes more sushi… Indian consumes more lentils… a reference commodity basket to measure purchasing power. Relative PPP makes predictions about price changes rather than price levels….

Hong Kongs exception to PPP …despite a fixed exchange rate and no trade barriers

Hong Kongs exception to PPP Profit from investment to the special economic zones Rich Hong Kong residents spent on the islands services and nontradables Land scarcity made real estate prices soar.

deviationsFloating exchange rates systematically lead to much larger and more frequent short-run deviations from relative PPP.

Why price levels are lower in poor countries? positively correlation

International variations in the prices of nontradables may contribute to price level discrepancies between rich and poor nations. Nontradables tend to be more expensive in richer countries.Nontradables tend to be more expensive in richer countries. Rich countries have higher capital-labor ratios, the marginal productivity of labor is greater in rich countries than in poor countries. …so does wage level…

Beyond PPP: A general model of long-run exchange rates The long-run analysis continues to ignore short-run complications caused by sticky prices. Skip over Page : nominal and real exchange rates in the long-run equilibrium.

Two Conclusions 1.when all disturbances are monetary in nature, exchange rates obey relative PPP in the long run. output unlikely 2.when disturbances occur in output markets, the exchange rate is unlikely to obey relative PPP, even in the long run.

Long run is important! Long-run factors are important for the short run because of the central role expectations about the future play in the day-to-day determination of exchange rates. The long-run exchange model will provide the anchor for market expectations.

Why does the yen keep rising?

JapanJapan : : fixed exchange rate In about 25 years the dollar had lost 2/3 of its foreign exchange value against the yen! After suffering through high inflation in 1973 and 1974, Japans leaders began to show a preference for lower inflation than in the U.S.

Balassa-Samuelson Effect [P.415] It assumes that the labor forces of poor countries are less productive than those of rich countries in tradable sector but that international productivity differences in nontradables are negligible. More about Balassa-Samuelson EffectMore about Balassa-Samuelson Effect.More about Balassa-Samuelson EffectMore about Balassa-Samuelson Effect

Empirical studies 13.2 % 73.2 %. Labor productivity growth in U.S. tradables exceeded that in U.S. nontradables by 13.2 % over the period. In Japan, productivity growth in tradables outstripped that in nontradables by a massive 73.2 %.

Japan case The greater the gap between factor productivity growth in tradables and nontradables, the greater the rise in the relative price of nontraded goods, on average. from Norway, leads in the gap between traded and nontraded productivity gains Japan leads the industrial countries in the rate of increase of its nontradables prices, and, aside from Norway, leads in the gap between traded and nontraded productivity gains.

a higher traded-nontraded productivity growth difference is associated with a higher rate of increase in the relative price of nontradables.

Non-tradables For some products, including many services, international transport costs are so steep that these products become nontradables.

Under the flexible-price monetary approach