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

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

3. 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

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

5. 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 €

6. 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

7. 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?

9. 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 €.

10. 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?

12. April 2002

13. McCurrencies: 2002 US Price = $2.49 P* E EP* e E/e
P* E EP* e E/e
Australia
Russia
Japan
Euroland

14. 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

15. April 2003

16. McCurrencies: 2003 US Price = $2.71 P* E EP* e E/e
P* E EP* e E/e
Australia
Russia
Japan
Euroland

17. 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

18. 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

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

20. 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

21. Law of One Price & Development

23. 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

24. 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 = (Ebaht/$ = 40)
$ price of Thailand Jeans = $10 = E$/baht (PT)
Is Baht overvalued?
No PT/Pus = Ebaht/$ = 40

25. 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

26. 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

27. 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?

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

29. 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

30. 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

31. 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

32. 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.

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

34. 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

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

36. Inflation and Exchange Rates
per year cumulative
Chile % %
India % %
Indonesia % %
Israel % %
Kenya % %
Mexico % %
South Africa % %
Tanzania % %

37. 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)

38. Inflation and Exchange Rates
Why do they have double digit inflation?
Double digit money growth
money growth inflation
SP club % %
CI club % %

39. 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)

40. Inflation and Exchange Rates
money growth inflation depreciation
SP club % %
CI club % % % 
71% over 10 years

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

42. 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.

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

44. Inflation and Exchange Rates
Argentina money inflation depreciation
growth (cumulative)
% % %
% % %

46. 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).

47. 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)

48. 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

49. 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 

50. Inflation and Interest Rates 1970 - 2000

51. Inflation and Interest Rates 1970 - 2000

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

53. Figure 15-1 Long-Run Time Paths of Economic Variables after a
Figure 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 = 