1. International Finance 130440-1165 Exchange rate movements in the long term International Finance 130440-1165

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

3. International Finance 130440-1165 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

4. International Finance 130440-1165 The law of one price  P GBP >P USD  imports from USA  price falls in GB  P USD = ER USD/GBP*P GB

5. International Finance 130440-1165 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

6. International Finance 130440-1165 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

7. International Finance 130440-1165 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

8. International Finance 130440-1165 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

9. International Finance 130440-1165 The absolute and relative version of PPP theory  The absolute version seem not to be confirmed empirically  RER does not equal 1!

10. International Finance 130440-1165 The PLN RER vs EUR Źródło: R. Kelm, Model behawioralnego kursu równowagi złotego do euro, Bank i Kredyt 41 (2), NBP, Warszawa 2010.

11. International Finance 130440-1165 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

12. International Finance 130440-1165 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%

13. International Finance 130440-1165 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

14. International Finance 130440-1165 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

15. International Finance 130440-1165 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

16. International Finance 130440-1165 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!

17. International Finance 130440-1165 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

18. International Finance 130440-1165 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

19. International Finance 130440-1165 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

20. International Finance 130440-1165 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

21. International Finance 130440-1165 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.

22. International Finance 130440-1165 Main factors impeding PPP  Barriers to trade  Non-tradable goods  Incompetitive market structures  Differences in consumption structures and prices  The Ballassa-Samuelson effect

23. International Finance 130440-1165 Barriers to trade  Transportation cost  Trade policy  Barriers to capital movement

24. International Finance 130440-1165 Nontradable goods  Services  No international price relation  Great share of nontradables in GDP

25. International Finance 130440-1165 The Big Mac Index

26. International Finance 130440-1165 Incompetitive market structures  Market segmentation  Price discrimination  Dumping prices

27. International Finance 130440-1165 Consumption structure differences  Different measures of prices and inflation  Majority of consumption- national products  Differences in consumption structure influence PPP ER

28. International Finance 130440-1165 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

29. International Finance 130440-1165 The Balassa-Samuelson effect  Higher inflation in the nontradables sector  Effect- countries with higher productivity  higher price level  RER >1  Especially- cathing up countries

30. International Finance 130440-1165 Extending the PPP theory  Real ER movements  Long term equilibrium on the FX market  International long term ineterest rate differentials

31. International Finance 130440-1165 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

32. International Finance 130440-1165 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

33. International Finance 130440-1165 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

34. International Finance 130440-1165 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

35. International Finance 130440-1165 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

36. International Finance 130440-1165 Real ineterest rate parity  The expected RER changes equal the expected real interest rate changes  ri ne -ri ae =(RER e -RER)/RER

37. International Finance 130440-1165 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

38. International Finance 130440-1165 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

39. International Finance 130440-1165 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 2009.  R. Clarida, J. Gali, Sources of real exchange rate fluctuations: how importanta are nominal shocks?, NBER Working Paper, 1994.  M. Wagner, J. Hlouskova, What’s really the story with this  Balassa-Samuelson Effect in the CEECs?, Diskussionschriften, Universität Bern, 2004