Chapter 15: Price Levels and the Exchange

Rate in the Long Run (part 1)

Outline
1.
2.
3.
4.
5.

Purchasing Power Parity (PPP)

Monetary approach to the exchange rate
Empirical evidence on PPP
General model of long-run exchange rate
Real interest rate parity

Law of One Price

Exchange rates can be used to convert the price of a
certain good into units of the same currency (compare
prices in different countries)
- Domestic and foreign goods that are very similar
expect equal prices when expressed in the same
currency (arbitrage)
Law of one price
- Identical goods sold in different countries must sell
for the same price (if their prices are expressed in
the same currency)

- Assume: competitive markets (costs of retailing),

no transportation costs, no official barriers to trade
(tariffs)
- Offers a link between domestic prices of goods and
the exchange rate:
PiSA = ER/$*PiUS
Or equivalently, ER/$ = PiSA/PiUS
Evidence
- For some highly traded commodities (oil and gold,
for example), law of one price holds fairly well

- The Economists Big Mac Index provides evidence

against the law of one price (Rakko & Pollard
(1996), Krugman & Obstfeld (Chapter 15))
o Transportation costs and government
regulations
o Product differentiation (some countries have
few close substitutes McD has power to set
prices)
o Non-tradable inputs (wages, rent, electricity,
etc. i.e. service costs)
o Exchange rates are more volatile than prices

PPP from Law of One Price

If law of one price holds and if weights in consumption
basket for goods are identical accross countries, then
PPP holds:
PSA = ER/$*PUS
- Determine the exchange rate from relative price
levels:
ER/$ = PSA /PUS
- Absolute PPP requires identical price levels
(unlikely when real world baskets are considered):
(ER/$*PUS)/PSA = 1

Relative PPP requires the relative price to be

constant, but not unity
(ER/$*PUS)/PSA = constant
Why might not absolute PPP hold?
- Transport costs and restrictions
- Monopolistic and oligopolistic practices
- Different countries use different baskets to
compute CPI
- Exchange rates are more volatile than prices
o

Monetary Approach to the Exchange Rate

Building blocks
- PPP: ER/$ = PSA /PUS
- Money demand in each country:
MSA/PSA = L(RR,YSA) PSA = MSA/L(RR,YSA)
MUS/PUS = L(R$,YUS) PUS = MUS/L(R$,YUS)
- Combine:
ER/$ = PSA /PUS = [MSA/L(RR,YSA)]/[MUS/L(R$,YUS)]
= [L(R$,YUS)*MSA/L(RR,YSA)*MUS]
- Take logarithms:
ln(ER/$) = ln(MSA) ln(MUS) + ln[L(R$,YUS)]
ln[L(RR,YSA)]
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Comparative statics:
ln(ER/$) = ln(MSA) ln(MUS) + ln[L(R$,YUS)]
ln[L(RR,YSA)]
- MSA increases (ceteris paribus)
- YSA increases (ceteris paribus)
- RR increases (ceteris paribus)
- Change in a single variable with others held
constant may not be realistic

Characteristics of Long-Run Equilibrium

Monetary neutrality
- In the long-run, percentage growth in money
supply is matched by the same percentage growth
in the price level
o Thus, real money supply (MSA/PSA) remains
unchanged (as does RR)
- Prices:
(Pt+1 Pt)/Pt = t+1 = (Mt+1 Mt)/Mt
- Exchange rates (E = ER/$):
(Et+1 Et)/Et = [(PSA,t+1 PSA,t)/PSA,t] - [(PUS,t+1
PUS,t)/PUS,t] = SA - US
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Fisher Effect
- Real interest rate is unaffected by inflation:
rR = RR - SA
- When SA increases, RR increases by the same
amount
Graphs of effects of an increase in money growth with
flexible prices
- MSA
- RR
- PUS
- ER/$

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