Price Levels and the Exchange Rate in the Long Run

1. Price Levels and the Exchange Rate in the Long Run Chapter 16 International Economics Udayan Roy

2. Overview • Long-run analysis • Real variables • Nominal variables • Flexible exchange rates • We will study fixed exchange rates in Chapter 18

3. The Real Exchange Rate • We discussed exchange rates in Chapter 14 • Example: €1 = $1.50 • Those exchange rates are nominal exchange rates • Now we’ll discuss real exchange rates

4. The Real Exchange Rate • Let us consider the price of an iPhone 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 iPhone in Europe costs as much as 1.5 iPhones in US • E × PE / PUS= 1.5 • This is the realdollar/euro Exchange Rate for iPhones

5. The Real Exchange Rate • In general, the real exchange rate is a broad summary measure of the prices of one country’s goods and services relative to another’s. • The real dollar/euro exchange rate is the number of US reference commodity baskets—not just iPhones—that one European reference commodity basket is worth • Equation (16-6) in KOM9e E$/€ is the nominal exchange rate, the price of one euro in dollars PE is the overall price level in Europe, such as the consumer price index PUS is the overall price level in the United States

6. Depreciation and Appreciation

7. The Real 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.

8. Real Depreciation and Appreciation • Real depreciation of the dollar against the euro • A rise in the real dollar/euro exchange rate (q$/€↑) • is a fall in the purchasing power of a dollar within Europe’s borders relative to its purchasing power within the United States • Or alternatively, a fall in the purchasing power of America’s products in general over Europe’s. • Real appreciation of the dollar against the euro is the opposite of a real depreciation: a fall in q$/€.

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

10. Law of One Price • Going back for a second to the iPhone 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.

11. Absolute and Relative PPP • Chapter 16 of the textbook (KOM9e) uses Absolute PPP in the first part of the chapter and Relative PPP in the second part • Absolute PPP: q = 1 • Relative PPP: q = a constant, not necessarily 1 • Although the results in the following slides have been proved for APPP, they are also true under RPPP

12. Prices and the Exchange Rate • Absolute PPP says: • Therefore, • Therefore, the faster domestic prices (P) grow, the faster the foreign currency’s exchange value (E) will grow • And, the faster foreign prices (P*) grow, the slower the foreign currency’s exchange value (E) will grow

13. Prices and the Exchange Rate Equation (16-2) of the textbook, KOM9e • In general, • where Eg is the growth rate of E. This is the appreciation rate of the foreign currency • π* is the foreign inflation rate, and • π is the domestic inflation rate • Example: If US inflation is 3% a year and Canadian inflation is 1% a year, then the exchange value of the Canadian dollar, measured in US dollars, will increase 2% a year

14. The Interest Rate • We have seen in Chapter 15 that the interest parity equation is • The second term on the right-hand side is the expected appreciation rate of the foreign currency • Assumption: The expected appreciation rate is assumed to be equal to the actual appreciation rate (Eg), in the long run

15. The Interest Rate • Therefore, • We saw two slides earlier that • Therefore, • Assumption: The foreign interest rate (R*) and the foreign inflation rate (π*) will be assumed to be exogenous constants Equation (16-5) of the textbook, KOM9e

16. The Interest Rate: Fisher Effect • As the foreign interest rate (R*) and the foreign inflation rate (π*) are assumed to be exogenous constants, any change in the domestic inflation rate will cause an equal change (both in magnitude and direction) in the domestic nominal interest rate • This is called the Fisher Effect

17. The Interest Rate • implies • R is the nominal interest rate. • It tells you how fast the dollar value of your wealth is increasing • R – π is the real (or, inflation-adjusted) interest rate. • It tells you how fast the purchasing power of your wealth is increasing • We now see that in the long run equilibrium, real interest rates must be equal in all countries

18. The Interest Rate • Assumption: The domestic inflation rate (π) is constant in the long run equilibrium • Then must also be constant in the long run equilibrium • We will now use this constancy of R to get a theory of long run inflation

19. Output • The real GNP produced when all resources are fully utilized is known by various names: • Long-run GNP • Natural GNP • Full-employment GNP • Potential GNP(Yp) • Assumption: In the long run, the economy makes full use of all its resources • Therefore, in long-run equilibrium, Y = Yp.

20. Inflation • We have seen in Chapter 15 that equilibrium in the money market implies • Moreover, • Simplifying a bit, • Therefore, in equilibrium, • Therefore,

21. Inflation • Therefore, in the long-run, • We saw three slides back that R is constant in the long run equilibrium. Moreover, L0 is an exogenous constant • Therefore, the faster the money supply (Ms) grows, the faster the price level (P) will grow • And, the faster potential GDP (Yp) grows, the slower the price level (P) will grow

22. Inflation • In general, • For example, if the Federal Reserve expands US money supply at the rate of 5% a year and if the US economy’s potential GDP increases at the rate of 3% a year, then, in the long run, the US inflation rate will be 2% a year.

23. The Interest Rate, again • So far, we have and • Therefore, the domestic nominal interest rate in the long run is , a constant

24. The Price Level • A few slides back, we saw that in the long run the domestic price level is • Moreover, we just saw that • Therefore, in the long run, the domestic price level is

25. Appreciation Rate of the Foreign Currency • We saw earlier that the foreign currency appreciates at the rate • As the inflation rate is , we can now write

26. The Exchange Rate: APPP version • Recall that under absolute purchasing power parity, we have , which implies • We have also seen two slides back that • Therefore,

27. Summary: Long-Run, Flexible Exchange Rates • q = 1, absolute PPP • Y = Yp 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.

28. Summary: Long-Run, Flexible Exchange Rates • q = 1, absolute PPP • Y = Yp Keep in mind that we are talking about the long run here. So, these equations show us the long run effects of permanent changes in the exogenous variables on the equations’ right-hand sides.

29. Summary: Long-Run, Flexible Exchange Rates • q = 1, absolute PPP • Y = Yp The first two variables are real variables: they can be measured even in barter (or, non-monetary) economies. The remaining variables are nominal variables: they make sense only on monetary economies. Note that the money supply (Ms) has no effect on real variables. This is an instance of monetary neutrality in the long run.

30. Summary: Long-Run, Flexible Exchange Rates • q = 1, absolute PPP • Y = Yp Flashback to Ch. 15 of the textbook (KOM9e): “A change in the supply of money has no effect on the long-run values of the interest rate or real output.” (p. 369) “A permanent increase in the money supply causes a proportional increase in the price level’s long-run value. In particular, if the economy is initially at full employment, a permanent increase in the money supply eventually will be followed by a proportional increase in the price level.” (p. 370)

31. 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.

32. Law of One Price for Hamburgers?

33. We will return to this after discussing Chapter 17 The balance on a country’s current account (CA) is roughly its net exports What does CA depend on in the long run? Bonus Topic: The Current Account

34. The Current Account • Recall the goods market equilibrium equation: • Therefore, • Recall that in the long run • Therefore,

35. The Current Account • If Yp increases by, say, $100, then, in the long run, income (Y) will increase by $100 and consumption (C) will increase, but by less than $100 • Therefore, CA will increase • Therefore, in the long run, Ypand CA move in the same direction

36. The Current Account • It is also straightforward to check that • When taxes (T) change, CA moves in the same direction, and • When I and G change, CA moves in the opposite direction • Fiscal austerity (T↑ or G↓) is a way to raise CA • A fall in consumer wealth—caused by, say, a real estate crash or a stock market crash—has the same effect as a tax increase. So, CA will increase!

37. The Long Run • The macroeconomic analysis of the long run is characterized by the concept of monetary neutrality • That is, monetary arrangements and monetary policy have no effect on the behavior of real variables • Therefore, the predictions summarized by the table on this and the previous slide are true for both the flexible exchange rate system of this chapter and the fixed exchange rate system of Chapter 18