Preview: 9/29, 10/1

1. Preview: 9/29, 10/1 • Quiz: Yfe… P … E • Moments to remember: Instant/Short-run/Long-run The Long-Run: Put on Your Monetarist Hat • Law of one price/Purchasing power parity in theory • Monetary approach to exchange rate • Fisher effect … another parity condition • PPP in practice • Deviations from PPP • Balassa-Samuelson / Bhagwati-Kravis-Lipsey • Real exchange rate approach • Real interest rate parity

2. Moments to Remember • “Temporary” change  Ee unchanged (Ee = E0) • “Permanent change  Ee = E*

3. Law of One Price / Purchasing Power Parity • The law of one price: the price of the same stuff in competitive markets measured in the same currency must be the same • Assume no transportation costs or other barriers to trade. PbourbonUS= E$/€ x PcognacEurope $/Bottle= ($/ €)x (€/Bottle) =$/Bottle • Purchasing power parity applies the law of one price across countries for all goods and services … really for representative groups (“baskets” or “bottles”) of goods and services. PUS= (E $/€ ) x (PEurope) • Purchasing power parity implies that E $/€ = PUS/Peurope • Levels of average prices determine the exchange rate. • People in all countries have the same purchasing power with their currencies: if US prices in dollars are twice as high as European prices in euros, $2 exchange for €1.

4. Purchasing power parity comes in 2 flavors: • Absolute PPP: E$/€ = PUS/PEU • Relative PPP: changes in exchange rates equal changes in prices (inflation) between two periods: Δ E$/€,t = (E$/€,t - E$/€, t –1)/E$/€, t –1 = US, t - EU, t where t = inflation rate from period t-1 to t • A country’s currency depreciates to the extent that its inflation rate exceeds the inflation rate abroad.

5. Shortcomings of PPP: The Yen/Dollar Exchange Rate and Relative Japan-U.S. Price Levels, 1980–2006 Source: IMF, International Financial Statistics. Exchange rates and price levels are end-of-year data.

6. PPP and the law of one price may not hold because of • Trade barriers and non-tradable products • Transport costs and governmental trade restrictions make trade expensive and in some cases create non-tradable goods or services. • Services are often not tradable: services are generally offered within a limited geographic region (for example, haircuts). • The greater the transport costs, the greater the range over which the exchange rate can deviate from its PPP value. • Imperfect competitionprice discrimination: “pricing to market.” • Differences in the measure of average prices for goods and services • levels of average prices differ across countries because of differences in how representative groups (“baskets”) of goods and services are measured. • Because measures of groups of goods and services are different, the measure of their average prices need not be the same. But we’ll treat PPP as valid in the long-run

7. Law of One Price for Hamburgers?

8. Law of One Price for Hamburgers?

9. Price Levels and Real Incomes, 2004 Source: Penn World Table, Mark 6.2.

10. Monetary Approach to Exchange Rates: A long –run view Monetary approach to the exchange rate: use absolute PPP : • In each country, prices adjust in the long-run so MsUS/PUS = L (R$, YUS) MsEU/PEU = L (R€, YEU) Monetary factors predict how exchange rates adjust in the long-run. PUS = MsUS/L (R$, YUS) PEU = MsEU/L (R€, YEU) and E $/€ = PUS/ PEU = [MsUS/L (R$, YUS)]/[MsEU/L (R€, YEU)] • The exchange rate is determined in the long run by prices, which are determined by the relative supply and demand of real monetary assets in money markets across countries.

11. Monetary approach predictions about exchange rate changes: • Money supply: a permanent rise in Ms • causes a proportional increase in the domestic price level • causing a proportional depreciation in the domestic currency (through PPP). … just as before (Chapter 14) 2. Output level (Y) : a rise in the long-run level of domestic production and income • raises domestic demand of real monetary assets • decreases long-run level of average domestic prices for Ms fixed • causing a proportional appreciation of the domestic currency (through PPP) … just as before (Quiz #3). 3. Interest rates (R): a rise in domestic interest rates • lowers the demand of real monetary assets • increases the long-run level of average domestic prices for Ms fixed • causing a proportional depreciation of the domestic currency (through PPP) • not like before (Chapter 14)! But what causes R to rise permanently (in the long-run)?

12. The Fisher Effect: Inflation and Interest Rates • The Fisher effect (named for Irving Fisher) describes the relationship between nominal interest rates and inflation. • The international Fisher effect derived from interest parity and relative PPP: R$- R€ = (Ee$/€- E$/€)/E$/€ = eUS - eEU A rise in the domestic inflation rate  an equal rise in the domestic interest rate in the long-run, ceteris paribus What causes inflation to increase? • A change in the Msgrowth rate  in a change in the growth rate of prices (inflation,). • A constant Ms growth rate  persistent price inflation () at the same constant rate, ceteris paribus. • Inflation does not affect productive capacity and real income in the long-run. • Inflation does affect the nominal interest rate via the Fisher effect.

13. Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money Supply: Assume flexible Price Level, P

14. Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money Supply • Immediate increase in expected inflation  an immediate increase in the nominal interest rate  an immediate decrease in the demand for real monetary assets. • For the money market to maintain equilibrium, the price level must jump up since PUS = MsUS/L(R$, YUS) Ms does not increase immediately but L(R$, YUS) declines immediately. • In order to maintain PPP, the exchange rate must jump immediately (the dollar must depreciate) so E$/€ = PUS/PEU • Thereafter, the money supply and prices grow at rate π + π and the domestic currency depreciates at the same rate, as was expected.

15. How a Rise in U.S. Monetary Growth Affects Dollar Interest Rates and the Dollar/Euro Exchange Rate When Goods Prices Are Flexible: The Movie

16. The Role of Inflation and Expectations Long run results from the model of Chapter 14 • changes in money supplylead to changes in the level of average prices. • no inflation is predict to occur in the long run, but only during the transition to the long run equilibrium. • During the transition, inflation causes the nominal interest rate to increase to its long run value. • Expectations of higher domestic price and currency depreciation cause the expected return on foreign currency deposits to increase, making the domestic currency depreciate before the transition period. • the level of average prices does not immediately adjust even if expectations of inflation adjust  the exchange rate overshoots Long run results from the monetary approach (with PPP), • the rate of inflation increases permanently when the growthrate of the money supply increases permanently. • With persistent domestic inflation (above foreign inflation), the monetary approach also predicts an increase in the domestic nominal interest rate. • Expectations of higher domestic inflation cause the expected purchasing power of domestic currency to decrease relative to the expected purchasing power of foreign currency, thereby making the domestic currency depreciate. • The level of average prices adjusts with expectations of inflation, causing the domestic currency to depreciate, but with no overshooting.

17. The Real Exchange Rate Approach to Exchange Rates • The real exchange rate: the rate of exchange for goods and services across countries. qUS/EU = (E$/€ x PEU)/PUS qUS/EU = ($/€ )x (€/cognac) / ($/bourbon) = (bourbon/cognac) Real depreciationof the value of U.S. products qUS/EU rises the dollar’s purchasing power of EU products relative to the dollar’s purchasing power of U.S. products falls … gotta give more Bourbon per Cognac The real exchange rate and the nominal rate: elaborating PPP E$/€ = qUS/EU x PUS/PEU • What changes qUS/EU? • An increase in relative demand for US products  real appreciation of “$” • An increase in relative supply of U.S. products  real depreciation of “$”

18. The Long-Run Real Exchange Rate Upward slope of RD: the more Bourbon Europeans get per Cognac, the more US stuff they demand relative to their own stuff. When the relative supply of US stuff matches the relative demand for US stuff, there is no tendency for the price of US Bourbon relative to the price of EU Cognac to change. In the long run, the supply of goods and services in each country depends on factors of production like labor, capital and technology—not prices or exchange rates.

19. The Real Exchange Rate Approach to Exchange Rates A more general approach to explain exchange rates. • Both monetaryandreal factors influence nominal exchange rates: 1a. increases in monetary levels temporary inflation and changes in expectations about the price level and exchange rate. 1b. increases in monetary growth rates  persistent inflation and changes in expectations about the rates of inflation and exchange rate depreciation. 2a. increases in relative demand for domestic products  a real appreciation. 2b. increases in relative supply of domestic products  a real depreciation. Effects of changes in real exchange rates on nominal exchange rates E$/€ = qUS/EU x PUS/PEU • When only monetary factors change and PPP holds, we have the same predictions as before: no changes in the real exchange rate occurs • When factors influencing real output change, the real exchange rate changes.

20. Effects of changes in real exchange rates on nominal exchange rates E$/€ = qUS/EU x PUS/PEU • When only monetary factors change and PPP holds, we have the same predictions as before: no changes in the real exchange rate occurs • When factors influencing real output change, the real exchange rate changes. • An increase in relative demand for domestic products real exchange rate appreciates as does the nominal exchange rate. • An increase in relative supply of domestic products: a more complex situation • An increase in the relative supply of domestic products qUS/EU depreciates • But the relative amount of domestic output increases, increasing Ld. PUS = MsUS/L (R$, YUS) • The level of average domestic prices is predicted to decrease relative to the level of average foreign prices. • The effect on the nominal exchange rate is ambiguous: E$/€ = qUS/EU x PUS/PEU ?

21. Interest Rate Differences: Nominal and Real • A more general equation of differences in nominal interest rates across countries can be derived from: qeUS/EU = Ee$/€ x PeUS/PeEU (qeUS/EU - qUS/EU)/qUS/EU = [(Ee$/€ - E$/€)/E$/€] – (eUS- eEU) From Interest Rate Parity: R$- R€ = (Ee$/€- E$/€)/E$/€ R$- R€ = (qeUS/EU - qUS/EU)/qUS/EU + (eUS- eEU) • The difference in nominal interest rates across two countries is now the sum of: • The expected rate of depreciation in the value of domestic goods relative to foreign goods (real depreciation) Plus • The difference in expected inflation rates between the domestic economy and the foreign economy

22. Interest Rate Differences: Nominal and Real • Real interest rate = re = Inflation-adjusted interest rate: re = R – πe • Real interest rates are measured in terms of real output: • the quantity of goods and services savers can buy when their assets pay interest • the quantity of goods and services borrowers cannot buy when they must pay interest Real interest rate differentials between countries are derived from reUS – reEU = (R$ - eUS) - (R € - eEU) Our previous result: R$- R€ = (qeUS/EU - qUS/EU)/qUS/EU + (eUS- eEU) So: reUS – reEU = (qeUS/EU - qUS/EU)/qUS/EU • The last equation is called real interest parity. • Differences in real interest rates between countries (in terms of goods and services that are earned when lending) equal the expected change in the value/price/cost of goods and services between countries. • A country must offer high real interest rates when its real exchange rate is expected to depreciate.