Price Levels and the Exchange Rate in the Long Run

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Price Levels and the Exchange Rate in the Long Run

• Chapter 16
• International Economics
• Udayan Roy

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(No Transcript)
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The Real Exchange Rate

• Let us consider the price of an iPod in US and
  Europe
• In US, it is PUS 200
• In Europe, it is PE 150
• The value of the euro is E 2 dollars per euro
• So, Europe's price in dollars is E PE 300
• So, each iPod in Europe costs as much as 1.5
  iPods in US
• E PE / PUS 1.5
• This is the Real dollar/euro Exchange Rate for
  iPods

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The Real Exchange Rate

• In general, the real exchange rate is a broad
  summary measure of the prices of one countrys
  goods and services relative to the other's.
• The real dollar/euro exchange rate is the number
  of US reference commodity basketsnot just
  iPodsthat one European reference commodity
  basket is worth
• Equation (16-6)

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the real dollar/euro exchange rate

• Example If the European reference commodity
  basket costs 100, the U.S. basket costs 120,
  and the nominal exchange rate is 1.20 per euro,
  then the real dollar/euro exchange rate (q/) is
  1 U.S. basket per European basket.

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Real depreciation and appreciation

• Real depreciation of the dollar against the euro
• A rise in the real dollar/euro exchange rate
  (q/?)
• is a fall in the purchasing power of a dollar
  within Europes borders relative to its
  purchasing power within the United States
• Or alternatively, a fall in the purchasing power
  of Americas products in general over Europes.
• Real appreciation of the dollar against the euro
  is the opposite of a real depreciation a fall in
  q/.

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Absolute PPP

• A very simple theory of the real exchange rate is
  called Absolute Purchasing Power Parity
• It says that
• q 1
• Why?

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Law of one price

• Going back for a second to the iPod example, one
  can argue that PUS, the dollar price in the US,
  ought to be equal to E PE, the dollar price in
  Europe. That is,
• E PE PUS.
• In general, E/ x PE PUS.
• Therefore, q/ (E/ x PE)/PUS 1.
• This is the Law of One Price or Absolute
  Purchasing Power Parity.

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Prices and the Exchange Rate

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Prices and the Exchange Rate

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The Interest Rate

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The Interest Rate

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The Interest Rate Fisher Effect

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The Interest Rate

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The Interest Rate

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Output

• The real GDP produced when all resources are
  fully utilized is known by various names
• Long-run GDP
• Natural GDP
• Full-employment GDP
• Potential GDP (Yp)
• It is assumed in long-run analysis that the
  economy makes full use of all its resources
• Therefore, in long-run equilibrium, Y Yp.

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Inflation

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Inflation

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Inflation

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The Interest Rate, again

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The Price Level

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Appreciation Rate of the Foreign Currency

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The Exchange Rate APPP version

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Summary, Long-Run

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The crucial point to note about these expressions
is that the variables on the right-hand sides of
these equations are all exogenous. As exogenous
variables are mystery variables about which our
theory has nothing to say, the equations on this
slide say all that our theory can say about the
endogenous variables on the left-hand sides of
these equations.
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Absolute PPP logical but not factual

• Despite the logical appeal of Absolute Purchasing
  Power Parity, available data suggests that it is
  not true
• We need to look for another theory of the real
  exchange rate, q.

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Law of One Price for Hamburgers?