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Exchange rate movements in the long term

Exchange rate movements in the long term. International Finance 130440-1165. Lecture outline. The law of one price The purchasing power parity (PPP) theory The monetary model and PPP Extensions of the PPP theory. The law of one price.

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Exchange rate movements in the long term

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

  3. 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 PGBP=30 GBP PUSD=45 USD International Finance 130440-1165

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

  5. 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 International Finance 130440-1165

  6. 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 International Finance 130440-1165

  7. The purchasing power parity theory • The PP of two currencies is measured with the real ER • RER= NER* Pn/Pa • NER*Pn/Pa=1 RER=1 International Finance 130440-1165

  8. The purchasing power parity theory • Overvalued currency if RER>1 it means: • NER* Pn>Pa • Undervalued currency if RER<1 it means: • NER* Pn>Pa • Arbitrage  Pn and NER decreases (or increases) so RER=1 International Finance 130440-1165

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

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

  11. 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 • (NERt-NERt-1)/NERt-1=Πnt-Πat International Finance 130440-1165

  12. Inflation differentials • According to the PPP theory the changes in the nominal ER are due to inflation differentials • Πn=3% Πa=1%  the national currency should depreciate at 2% p.a. • NERt/NERt-1=101/103=98% International Finance 130440-1165

  13. 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 International Finance 130440-1165

  14. The monetary model based on PPP • Assumption: NER= Pn/Pa so the PPP is fullfilled • Pn=Mn/L(in, Yn) • Pa= Ma/L(ia, Ya) • NER is determined in the long term by the relative money supply and demand in two countries International Finance 130440-1165

  15. 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 International Finance 130440-1165

  16. 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! International Finance 130440-1165

  17. 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 International Finance 130440-1165

  18. The monetary model based on PPP • Πe=(Pe-P)/P • (NERe-NER)/ NER= Πen- Πea • in= ia+ (NERe-NER)/NER • in- ia = Πen- Πea International Finance 130440-1165

  19. The Fisher effect • in- ia = Πen- Πea • 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 International Finance 130440-1165

  20. 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 International Finance 130440-1165

  21. 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. International Finance 130440-1165

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

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

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

  25. The Big Mac Index International Finance 130440-1165

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

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

  28. 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 International Finance 130440-1165

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

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

  31. Real exchange rate movements • RER depreciation • RER appreciation • Example: • NER USD decreases from 0,7 to 0,6 EUR/USD • ΠEUR= 105 and ΠUSD=130 • This means USD RER appreciation • RERt/RERt-1= (NERt/NERt-1)* Πn/Πa =(0,6/0,7)*(130/105)= 1,06 International Finance 130440-1165

  32. Long term equilibrium on the FX market • NER=RER*(Pn/Pa) • by given RER the NER is influenced by money demand and supply • by given money demand and supply NER is influenced by RER International Finance 130440-1165

  33. 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 International Finance 130440-1165

  34. Long term equilibrium on the FX market • If all shock are monetary in along 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 International Finance 130440-1165

  35. International long term interest rate differentials • Interest rate differentials depend not only on inflation expectations but also on expected RER • in-ia= (NERe-NER)/NER +(Πen - Πea ) • The interest rate differential equals the expected real depreciation of the ER and expected inflation differentials International Finance 130440-1165

  36. Real ineterest rate parity • The expected RER changes equal the expected real interest rate changes • rine-riae=(RERe-RER)/RER International Finance 130440-1165

  37. Summing up • No empirical evidence of the absolute version of the PPP theory NER*Pn/Pa=1 RER=1 • The relative version of the PPP theory (NERt-NERt-1)/NERt-1=Πnt-Πat • Empirical evidence only in the long term International Finance 130440-1165

  38. Summing up • The monetary model based on PPP • The Fisher effect in- ia = Πen- Πea • Factors impeding the PPP theory • Extensions of the PPP theory International Finance 130440-1165

  39. References • P. Krugman, M.Obstfeld, International economics: theory and policy. Part II, Pearson, Addison Wesley, Boston2009 • 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 International Finance 130440-1165

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