Chapter Eighteen The Exchange Rate in Long-Run Equilibrium

2 Chapter Eighteen Outline 1.Introduction 2.Money in Long-Run Equilibrium 3.Purchasing Power Parity 4.The Monetary Approach to the Exchange Rate 5.The Real Exchange Rate 6.Long-Run Equilibrium Exchange Rates 7.More on Why Interest Rates Differ

3 Introduction This chapter will examine long-run equilibrium under a flexible exchange rate and explore the relationships among key macroeconomic variables once the price level has adjusted completely to any change in the economy. –In long-run equilibrium, the economy satisfies two conditions: 1.Output reaches full employment level, determined by how much capital and labor the economy contains, as well as by the available technology, and by how much individuals choose to work; and 2.All prices in the economy reach levels consistent with equilibrium in their respective markets.

4 Introduction We will study how the exchange rate behaves in long-run equilibrium. –Requires an understanding of the long-run relationship among the country’s money stock, price level, and exchange rate.

5 Money in Long-Run Equilibrium How does money affect real output? –What effect does a one-time permanent change in the size of the money stock have on the economy’s long-run equilibrium real output? The answer is none. –Name for this result? Neutrality of money How does money affect the interest rate? –Has no effect on the long-run equilibrium interest rate.

6 Money in Long-Run Equilibrium How does money affect the price level? –In long-run equilibrium, one-time changes in the money stock lead to proportional changes in the price level. Figure 18.1 compares money stocks and price levels: –Horizontal axis measures average annual % increase in each country’s money stock, less 3% to allow for increases in full employment real output. –Vertical axis measures average annual % increase in each country’s price level (CPI). In long-run, countries with high rates of money growth experience higher rates of inflation than countries with lower rates of money growth.

7 Figure 18.1: Money Stocks and Price Levels, Average Adjusted Annual Increase in Nominal Money Stock (Percent) Average Annual Increase in Price Level (Percent) Canada Neth. Germany Japan Norway Greece Iceland Ireland Australia Austria 45 U.S. Switz.

8 Money in Long-Run Equilibrium A graph of money-market equilibrium can summarize the long-run equilibrium relationship among M, P, Q, and I, as in Figure 18.2: –In long-run equilibrium, a change in the nominal money stock exerts no effect on real output or the interest rate. Money demand remains unchanged, and the price level must change proportionally with the nominal money stock to maintain equilibrium.

9 Figure 18.2: Long-Run Equilibrium in the Money Market i i 0 0 Quantity of Real Money Balances L(Q 0, i) (M 1 > M 0 ) (P 1 > P 0 ) (M 0 /P 0 ) = (M 1 /P 1 )

10 Money in Long-Run Equilibrium How does money affect the exchange rate? –In long-run equilibrium, increases in money stock lead to proportional nominal depreciations of the domestic currency; decreases in money stock lead to proportional nominal appreciation. Figure 18.3: an increase in nominal money stock does not change the interest rate. –However, market participants anticipate proportional increases in all money prices, including the nominal exchange rate. Rise in e e increases demand for foreign-currency- denominated deposits and causes a proportional spot depreciation of the domestic currency.

11 Figure 18.3: Long-Run Equilibrium in the Foreign Exchange Market e e 0 0 Quantity of Foreign-Currency- Denominated Deposits D FX (i 0, i 0, e 0 ) (e 1 > e 0 ) S FX I II e 1 ee e D FX (i 0, i 0, e 1 ) e * *

12 Purchasing Power Parity Purchasing power parity (PPP) offers a linkage between price levels and nominal exchange rates. –Key building block for PPP is the law of one price: Identical goods will sell for an equivalent price regardless of the currency in which the price is denominated. –Complications such as transportation costs, tariffs, or nontariff barriers to trade can prevent the law of one price from holding. Evidence indicates that, even for identical traded goods, large deviations in prices occur. Trade barriers introduce artificial price differences that can cause the law not to hold. For nontraded items (products not traded globally) the law may hold even more loosely.

13 Purchasing Power Parity Going from the law of one price to PPP. –PPP carries the law of one price one step further by applying the logic not to the price of a single good, but to countries’ overall price levels. The price level in one country equals the price level in a second multiplied by the exchange rate between the countries’ currencies. For U.S. and Britain: p U.S. = e p B –The U.S. price level measures the dollar price of a basket of goods, and the British price level measures the pound price of a basket of goods. Therefore, PPP holds when the two countries’ price levels are equal once translated into a common currency using the exchange rate.

14 Purchasing Power Parity Absolute and relative PPP –Absolute PPP represents the strongest form, because it requires a strict relationship between the two countries’ price levels to hold continually. –Under a weaker form of parity, relative PPP, the percentage change in the domestic country's price level equals the percentage change in the foreign country’s, plus the percentage change in the exchange rate between the two countries’ currencies.

15 Purchasing Power Parity How can PPP not hold? –Transportation cost, tariffs, and NTBs are several factors that can cause PPP not to hold. These cause the law of one price – and therefore, PPP – not to hold, and they may do the same with relative PPP if transportation costs or trade barriers change over time.

16 Purchasing Power Parity Does PPP hold? –The relative PPPs of several countries are examined in Figure 18.4: Relative PPP implies that the rate of change in the exchange rate between two countries’ currencies equals the countries’ inflation differential. –The horizontal axis measures the % change in each country's price level minus the % change in the U.S. price level. –The vertical axis measures the % change in the price of the dollar measured in each country’s currency. If PPP held perfectly, all points would lie on the 45° line. Deviations from this line represent real appreciation of the yen, pound, and lira, along with real depreciation of the mark and Canadian dollar.

17 Figure 18.4: Relative Purchasing Power Parity, (Percent) 45º -1 Change in CPI Minus Change in U.S. CPI Change in Domestic-Currency Price of U.S. Dollar Canada U.K. France Germany Japan Italy

18 Purchasing Power Parity Cautionary notes on PPP –Little reason to expect PPP to hold over short or medium term. –Arguments that a currency is under- or over- valued based on PPP rest on a misunderstanding of PPP. Under flexible exchange rate regimes, under- and over- valued carry little meaning, because supply and demand determine the rates. –PPP does not imply that either inflation rates determine exchange rates or vice versa.

19 Purchasing Power Parity Cautionary notes on PPP (cont.) –Be careful with the “hamburger standard” test published annually in The Economist. They: 1.Collect the local-currency price of a Big Mac in 33 countries; 2.Translate this price into dollars at current exchange rates; and 3.Report that the foreign currency is over-valued (under-valued) against the dollar by the amount by which the dollar price of the foreign burger exceeds (falls short of) the dollar price of the U.S. burger.

20 Purchasing Power Parity Cautionary notes on PPP (cont.) –At least two problems with the burger-based PPP test: 1.The use of a single good, the Big Mac, means that the test can at best evaluate the law of one price, not PPP. 2.Even as a test of the law of one price, the Big Mac represents a poor choice, because as a restaurant meal it is not a traded good.

21 Monetary Approach to the Exchange Rate History and intuition behind the monetary approach. –The monetary approach to the exchange rate assumes that the primary role of the exchange rate in the macroeconomy is to equate the quantities supplied and demanded of various monies or currencies. Any event that alters either the quantity of money balances demanded or the money stock will alter the exchange rate according to the monetary approach.

22 Monetary Approach to the Exchange Rate A simple monetary model of the exchange rate. –The relative rates of growth of the supplies of and demands for different monies determine movements in the exchange rate. Exchange rate between two countries depends on money supply and demand in both economies. Algebraically:

23 Monetary Approach to the Exchange Rate What does the monetary approach to the exchange rate tell us? –Other things being equal, a one-time permanent rise in the domestic money stock causes a proportional increase in the domestic price level and, through PPP, a proportional depreciation of the domestic currency. Similarly, a one-time permanent increase in the foreign money stock raises the foreign price level and appreciates the domestic currency proportionally in the long run.

24 Monetary Approach to the Exchange Rate PPP and long-run interest parity with inflation. –When the money stock grows continually, prices in the economy must continually adjust. The result is inflation, which simply means a continuing rise in the price level. Differences in countries’ nominal interest rates, in long- run equilibrium, reflect differences in their expected inflation:

25 Monetary Approach to the Exchange Rate Real and nominal rates of return. –The nominal interest rate, i, measures an asset’s rate of return measured in units of the domestic currency. Nominal rate of return on an investment equals the rate of return measured in dollars. Real rate of return equals the return measured in real terms (that is, purchasing power over goods and services) rather than in dollars. Fisher equation states that the real return on any asset equals the nominal rate of return minus the rate of inflation:

26 Monetary Approach to the Exchange Rate Interest and exchange rates in the monetary approach. –The relationships are examined in Figure 18.6: To maintain assets’ real rates of return, nominal interest rate must incorporate changes in the rate of inflation. Within each country, nominal interest rates rise and fall with the country’s inflation. Across countries, those with higher inflation exhibit higher nominal interest rates.

27 Figure 18.5a: Inflation and Nominal Rates

28 Figure 18.5b: Inflation and Nominal Rates

29 Figure 18.5c: Inflation and Nominal Rates

30 The Real Exchange Rate Changes in the real exchange rate –Real depreciation of the domestic currency: a decline in the real exchange rate. –A rise in the real exchange rate represents a real appreciation of the domestic currency. –Real exchange rates can change dramatically – and trends in real exchange rates can last for decades.

31 The Real Exchange Rate What can cause changes in the real exchange rate? –Figure 18.7 shows how the relative output demand affects the real exchange rate: The real exchange rate (R = P/eP*) represents the relative price of domestic and foreign goods. –When demand for foreign goods rises relative to demands for domestic goods, RD shifts left. –At the old exchange rate, R 0, there is an excess supply of domestic goods and excess demand for foreign goods. The domestic currency depreciates in real terms to make domestic goods relatively cheaper, increase relative demand for domestic goods, and bring it back into equality with relative output supply at a real exchange rate of R 1.

32 Figure 18.6: Relative Output Demand Affects the Real Exchange Rate R 0 0 Relative Demand and Supply of Domestic and Foreign Goods RS 0 RD 1 (R) __ RD 0 (R) __ Q 0 /Q 0 * R 1 R  P / eP *

33 The Real Exchange Rate Figure 18.8 shows how the relative output supply affects the real exchange rate: –A rise in the long-run equilibrium level of foreign output (Q*) shifts RS left. At original exchange rate, R 0, there is excess demand for domestic goods and excess supply for foreign ones. –The domestic currency appreciates to make domestic goods relatively more expensive, reduce relative demand for domestic goods, and bring it back into equality with relative output supply at a real exchange rate of R 1.

34 Figure 18.7: Relative Output Supply Affects the Real Exchange Rate R 0 0 Relative Demand and Supply of Domestic and Foreign Goods RS 0 RD(R) __ Q 0 /Q 0 * R 1 R  P / eP * RS 1 Q 0 /Q 1 * (Q 1 > Q 0 ) *

35 Long-Run Equilibrium Exchange Rates How do long-run equilibrium exchange rates respond to various shocks to the economy? –Changes in relative money stock: no effect on long- run equilibrium real exchange rates. –Changes in relative money growth rates: no effect. –Increase (decrease) in output demands: real exchange rate increases (decreases). –Increase (decrease) in relative output supplies: real exchange rate decreases (increases).

36 More on Why Interest Rates Differ Interest rate parity suggests that interest rate differences reflect market participants’ expectations about future currency appreciations and depreciations. –To hold assets denominated in currencies expected to appreciate, portfolio owners willingly accept lower nominal interest rates.

37 More on Why Interest Rates Differ Purchasing power parity implies that long-run equilibrium nominal exchange rate movements reflect differences in countries’ rates of inflation. –If, in long-run equilibrium, changes in the expected nominal exchange rate include both relative inflation rates and changes in real exchange rates, then changes in the expected nominal exchange rate should include both expected relative inflation rates and changes in expected real exchange rates.

38 More on Why Interest Rates Differ While nominal interest parity equates the nominal interest differential to the expected change in the nominal exchange rate, real interest parity equates the real interest differential to the expected change in the real exchange rate. –This suggests that when all disturbances are monetary, implying that PPP is expected to hold, real expected interest rates should be equal across countries. But if non-monetary shocks are expected to cause deviations from PPP, real interest rates can differ, even in long-run equilibrium.

39 Notes for Case 5: Nontraded Goods and the Real Exchange Rate Balassa-Samuelson effect: the link between differential productivity growth and the real exchange rate. –Differences in countries’ rates of productivity growth can cause changes in real exchange rates, or deviations from PPP. –Balassa-Samuelson implies that rich countries’ price levels should be higher than those of poor countries.

40 Notes for Case 5: Nontraded Goods and the Real Exchange Rate Figure 18.8 offers empirical evidence of the Balassa- Samuelson effect: –The evidence clearly supports the implication that countries’ price level would be positively related to their per capita incomes. The theory is less successful in explaining variation, either within rich countries as a group or within poor countries as a group.

41 Figure 18.8: Rich Countries’ Price Levels are Higher than Those of Poor Countries Per Capita GDP/U.S. Per Capita GDP Gabon Greece Cyprus Israel Ireland Spain U.K. Netherlands Italy Austria Japan France Belgium Australia U.S.A. Canada Luxembourg Germany Iceland Norway Sweden Denmark Finland Switzerland Taiwan Singapore New Zealand Hong Kong Portugal Uruguay Hungary Czechoslovakia Trinidad and Tobago Syria Price Level (U.S. = 1) 0

42 Notes for Case Five: Nontraded Goods and the Real Exchange Rate All else equal, prices of services tend to be higher in countries with higher per-capita incomes

43 Key Terms in Chapter 18 Long-run equilibrium Neutrality of money Law of one price Purchasing power parity (PPP) Absolute purchasing power parity Relative purchasing power parity

44 Key Terms in Chapter 18 Monetary approach to the exchange rate Inflation Nominal rate of return Real rate of return Fisher equation Real depreciation

45 Key Terms in Chapter 18 Real appreciation Real interest parity Balassa-Samuelson effect