International Finance Exchange rate movements in the long term International Finance

Lecture outline  The law of one price  The purchasing power parity (PPP) theory  The monetary model and PPP  Extensions of the PPP theory

International Finance The law of one price  Assumption: no barriers to trade, no transportation costs  The price of identical goods should be equal in different countries if expressed in the same currency  Example:  If ER=1,5 USD/GBP P GBP =30 GBP P USD =45 USD

International Finance The law of one price  P GBP >P USD  imports from USA  price falls in GB  P USD = ER USD/GBP*P GB

International Finance The purchasing power parity theory  The purchasing power (PP) of a currency is reflected in the nominal price of a reference basket of goods and services.  If one can buy the same basket for 30 GBP and for 45 USD the PP of the GBP is higher than of the USD

International Finance The purchasing power parity theory  The nominal ER of two currencies conforms the PPP if for a unit of a currency we can purchase the same basket of goods in our country and abroad

International Finance The purchasing power parity theory  The PP of two currencies is measured with the real ER  RER= NER* P n /P a  NER*P n /P a =1  RER=1

International Finance The purchasing power parity theory  Overvalued currency if RER>1 it means:  NER* P n >P a  Undervalued currency if RER<1 it means:  NER* P n >P a  Arbitrage  P n and NER decreases (or increases) so RER=1

International Finance The absolute and relative version of PPP theory  The absolute version seem not to be confirmed empirically  RER does not equal 1!

International Finance The PLN RER vs EUR Źródło: R. Kelm, Model behawioralnego kursu równowagi złotego do euro, Bank i Kredyt 41 (2), NBP, Warszawa 2010.

International Finance The absolute and relative version of PPP theory  The relative version of the theory:  the NER changes of one currency equal the difference between the domestic price changes and abroad  (NER t -NER t-1 )/NER t-1 =Π nt -Π at

International Finance Inflation differentials  According to the PPP theory the changes in the nominal ER are due to inflation differentials  Π n =3% Π a =1%  the national currency should depreciate at 2% p.a.  NER t /NER t-1 =101/103=98%

International Finance Empirical verification of PPP  Empirical proofs only in a longer term  The PPP RER is offen used to compare wealth in different countries  Problem- consumption structure  Depending on the reference basket- there are several RER PPP

International Finance The monetary model based on PPP  Assumption: NER= Pn/Pa so the PPP is fullfilled  P n =M n /L(i n, Y n )  P a = M a /L(i a, Y a )  NER is determined in the long term by the relative money supply and demand in two countries

International Finance The monetary model based on PPP  Money supply increase  price increase  currency depreciation  Interest rate increase  decrease of money demand by constant money supply  increase of prices  depreciation  Production increase  money demand increase  price decrease  appreciation

International Finance The monetary model based on PPP  Puzzling evidence??  The influence of interest rate changes on ER depends on the reason why the interest rate changed!

International Finance The monetary model based on PPP  Raising money supply  Persistent inflation  The interest rate parity and PPP  If people expect the PPP theory to hold, the interest rate difference between two countries equals the difference between the expected inflation in those two countries

International Finance The monetary model based on PPP  Π e =(P e -P)/P  (NER e -NER)/ NER= Π en - Π ea  i n = i a + (NER e -NER)/NER  i n - i a = Π en - Π ea

International Finance The Fisher effect  i n - i a = Π en - Π ea  The increase of the expected inflation in one country causes in a long term an identical increase of the interest rate denominated in the currency of this country

International Finance The Fisher effect  The effect holds only in long term  It explains the paradox of the relation between ir changes and er changes  In the short term- sticky prices

International Finance The empirical verification of the relative PPP theory Źródło: R. Kelm, Model behawioralnego kursu równowagi złotego do euro, Bank i Kredyt 41 (2), NBP, Warszawa 2010.

International Finance Main factors impeding PPP  Barriers to trade  Non-tradable goods  Incompetitive market structures  Differences in consumption structures and prices  The Ballassa-Samuelson effect

International Finance Barriers to trade  Transportation cost  Trade policy  Barriers to capital movement

International Finance Nontradable goods  Services  No international price relation  Great share of nontradables in GDP

International Finance The Big Mac Index

International Finance Incompetitive market structures  Market segmentation  Price discrimination  Dumping prices

International Finance Consumption structure differences  Different measures of prices and inflation  Majority of consumption- national products  Differences in consumption structure influence PPP ER

International Finance The Balassa-Samuelson effect  The price level in countries with higher labour productivity grwoth is higher than in countries with lower productivity growth  Differences in productivity growth in tradables and nontradables sectors  Productivity growth  wages growth in both sectors

International Finance The Balassa-Samuelson effect  Higher inflation in the nontradables sector  Effect- countries with higher productivity  higher price level  RER >1  Especially- cathing up countries

International Finance Extending the PPP theory  Real ER movements  Long term equilibrium on the FX market  International long term ineterest rate differentials

International Finance Real exchange rate movements  RER depreciation  RER appreciation  Example:  NER USD decreases from 0,7 to 0,6 EUR/USD  Π EUR = 105 and Π USD =130  This means USD RER appreciation  RER t /RER t-1 = (NER t /NER t-1 )* Π n/ Π a =(0,6/0,7)*(130/105)= 1,06

International Finance Long term equilibrium on the FX market  NER=RER*(P n /P a )  by given RER the NER is influenced by money demand and supply  by given money demand and supply NER is influenced by RER

International Finance Long term equilibrium on the FX market  Shifts in relative money supply  Shifts in relative money supply growth rates  Shifts in relative demand for products  Shifts in relative supply of products

International Finance Long term equilibrium on the FX market  If all shock are monetary in a long term the RER conforms PPP!!!  Monetary shocks influence only the PP which changes the ER  If real shocks occure- the ER does not conform to PPP

International Finance International long term interest rate differentials  Interest rate differentials depend not only on inflation expectations but also on expected RER  i n -i a = (NER e -NER)/NER +(Π en - Π ea )  The interest rate differential equals the expected real depreciation of the ER and expected inflation differentials

International Finance Real ineterest rate parity  The expected RER changes equal the expected real interest rate changes  ri ne -ri ae =(RER e -RER)/RER

International Finance Summing up  No empirical evidence of the absolute version of the PPP theory NER*P n /P a =1  RER=1  The relative version of the PPP theory (NER t -NER t-1 )/NER t-1 =Π nt -Π at  Empirical evidence only in the long term

International Finance Summing up  The monetary model based on PPP  The Fisher effect i n - i a = Π en - Π ea  Factors impeding the PPP theory  Extensions of the PPP theory

International Finance References  P. Krugman, M.Obstfeld, International economics: theory and policy. Part II, Pearson, Addison Wesley, Boston 2009  R. Kelm, Model behawioralnego kursu równowagi złotego do euro, Bank i Kredyt 41 (2), NBP, Warszawa 2010  M. Rubaszek, Economic convergence and the fundamental equilibrium exchange rate in Poland, Bank i Kredyt 40 (1), NBP, Warszawa  R. Clarida, J. Gali, Sources of real exchange rate fluctuations: how importanta are nominal shocks?, NBER Working Paper,  M. Wagner, J. Hlouskova, What’s really the story with this  Balassa-Samuelson Effect in the CEECs?, Diskussionschriften, Universität Bern, 2004