Chapter 5 Price Levels and the

Exchange Rate in the Long Run

Learning Objectives
1 Explain the purchasing power parity theory of exchange
rates and the theory’s relationship to international goods-
market integration.
2 Describe how monetary factors such as ongoing price level
inflation affect exchange rates in the long run.
3 Discuss the concept of the real exchange rate.
4 Understand factors that affect real exchange rates and
relative currency prices in the long run.
5 Explain the relationship between international real interest
rate differences and expected changes in real exchange
rates.
The Behavior of Exchange Rates
• What models can predict how exchange rates behave?
– Last chapter we developed a short-run model and a long-
run model that used movements in the money supply.
– In this chapter, we develop 2 more models, building on
the long-run approach from last chapter.
– Long run means a sufficient amount of time for prices of
all goods and services to adjust to market conditions so
that their markets and the money market are in
equilibrium.
– Because prices are allowed to change, they will influence
interest rates and exchange rates in the long-run models.
The Behavior of Exchange Rates
• The long-run models are not intended to be completely
realistic descriptions about how exchange rates behave,
but ways of representing how market participants may
form expectations about future exchange rates and how
exchange rates tend to move over long periods.
Preview
• Law of one price
• Purchasing power parity (PPP)
• Long-run model of exchange rates: monetary approach
• Relationship between interest rates and inflation: Fisher
effect
• Shortcomings of PPP
• Long-run model of exchange rates: real exchange rate
approach
• Real interest rates
Law of One Price and PPP
Law of One Price
• The law of one price simply says that the same good in
different competitive markets must sell for the same price,
when transportation costs and barriers between those
markets are not important.
– Why?
 Suppose the price of pizza at one restaurant is $20,
while the price of the same pizza at an identical
restaurant across the street is $40.
– What do you predict will happen?
 Many people will buy the $20 pizza, few will buy the
$40 one.
Law of One Price
– Due to the price difference, entrepreneurs would have
an incentive to buy pizza at the cheap location and sell
it at the expensive location for an easy profit.

– Due to strong demand and decreased supply, the price

of the $20 pizza would tend to increase.

– Due to weak demand and increased supply, the price of

the $40 pizza would tend to decrease.

– People would have an incentive to adjust their behavior

and prices would tend to adjust until one price is
achieved across markets (across restaurants).
Law of One Price
• Consider a pizza restaurant in Seattle and one across the
border in Vancouver.
• The law of one price says that the price of the same pizza
(using a common currency to measure the price) in the two
cities must be the same if markets are competitive and
transportation costs and barriers between markets are not
important.

𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
𝑃𝑃𝑈𝑈𝑈𝑈 = EUS$/C$ × 𝑃𝑃𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
5 USD = 0.5 X 10 CD
 Purchasing Power Parity
• Purchasing power parity (PPP) is the application of the
law of one price across countries for all goods and services,
or for representative groups (“baskets”) of goods and
services.

PUS = ( EUS$/C$ ) × ( PCanada )

PUS = level of average prices in the U.S.
PCanada = level of average prices in Canada
EUS$/C$ = [Link]/Canadian doller exchange rate
Purchasing Power Parity
• PPP implies that the exchange rate is determined by levels
of average prices
PUS
E US$ =
C$
PCanada

– If the price level in the U.S. is US$200 per basket,

while the price level in Canada is C$400 per basket,
PPP implies that the US$/C$ exchange rate should be
US$200/C$400 = US$1/C$2 = 0.5 US$/C$.
– Predicts that people in all countries have the same
purchasing power with their currencies: 2 Canadian
dollars buy the same amount of goods as 1 U.S. dollar,
since prices in Canada are twice as high.
Purchasing Power Parity
• PPP comes in 2 forms:
• Absolute PPP: purchasing power parity that has already
been discussed. Exchange rates equal the level of relative
average prices across countries.
PUS
E$ / € =
PEU
• Relative PPP: percentage changes in exchange rates
equal changes in prices (inflation) between two periods:
(E$ / €,t − E$ / €, t −1 )
= π US,t − π EU,t
E$ / €, t −1
where π t inflation rate from perid t − 1 to t
Purchasing Power Parity
• Relative PPP example:
– Prices in Vietnam increase 5%
– Prices in US increase 2%
– Relative PPP predicts USD will appreciate 3% against
the dong
– To keep purchasing power the same, need a USD to
be able to buy more dong than before because prices
increased in Vietnam
(𝐸𝐸$/₫,𝑡𝑡 − 𝐸𝐸$/₫,𝑡𝑡−1 )
= 𝜋𝜋US,𝑡𝑡 − 𝜋𝜋VN,𝑡𝑡
𝐸𝐸$/₫,𝑡𝑡−1
-3% = 2% - 5%
 A Long-Run Exchange
Rate Model Based on PPP
Monetary Approach to Exchange
Rates
• Monetary approach to the exchange rate: uses
monetary factors to predict how exchange rates adjust in
the long run, based on the absolute version of PPP.
– It starts with the prediction that levels of average prices
across countries adjust so that real money supplied will
equal real money demanded:
Remember from last
𝑀𝑀𝑠𝑠
S
chapter: = 𝐿𝐿(𝑅𝑅, 𝑌𝑌)
M US 𝑃𝑃
PUS =
L ( R$ ,YUS )

M S EU
PEU =
L ( R€ ,YEU )
Monetary Approach to Exchange
Rates
• If PPP holds and prices adjust to equate the real
supply and demand of money, we have the following
prediction :
– The exchange rate is determined in the long run
by prices, which are determined by the relative
(nominal) money supply and real money demand
in money markets across countries.

𝑃𝑃US 𝑀𝑀 𝑆𝑆 US /𝐿𝐿 𝑅𝑅$ , 𝑌𝑌US

𝐸𝐸$/€ = = 𝑆𝑆
𝑃𝑃EU 𝑀𝑀 EU /𝐿𝐿 𝑅𝑅€ , 𝑌𝑌EU
Monetary Approach to Exchange
Rates
Important predictions:

1. Money supply: a permanent rise in the domestic money supply

– causes a proportional increase in the domestic price level,
– thus causing a proportional depreciation in the domestic
currency (through PPP).
– This is same prediction as long-run model without PPP.
𝑆𝑆
𝑀𝑀𝑈𝑈𝑈𝑈 ↑ → 𝑃𝑃𝑈𝑈𝑈𝑈 ↑ → 𝐸𝐸$/€ ↑

𝑃𝑃US 𝑀𝑀 𝑆𝑆 US /𝐿𝐿 𝑅𝑅$ , 𝑌𝑌US

𝐸𝐸$/€ = = 𝑆𝑆
𝑃𝑃EU 𝑀𝑀 EU /𝐿𝐿 𝑅𝑅€ , 𝑌𝑌EU
Monetary Approach to Exchange
Rates
2. Interest rates: a rise in domestic interest rates
– lowers the demand of real monetary assets,
– and is associated with a rise in domestic prices,
– thus causing a proportional depreciation of the domestic
currency (through PPP).

𝑅𝑅$ ↑ → 𝐿𝐿 𝑅𝑅$ , 𝑌𝑌𝑈𝑈𝑈𝑈 ↓ → 𝑃𝑃𝑈𝑈𝑈𝑈 ↑ → 𝐸𝐸$/€ ↑

𝑃𝑃US 𝑀𝑀 𝑆𝑆 US /𝐿𝐿 𝑅𝑅$ , 𝑌𝑌US

𝐸𝐸$/€ = = 𝑆𝑆
𝑃𝑃EU 𝑀𝑀 EU /𝐿𝐿 𝑅𝑅€ , 𝑌𝑌EU
Monetary Approach to Exchange
Rates
3. Output level: a rise in the domestic level of production and
income (output)
– raises domestic demand of real monetary assets,
– and is associated with a decreasing level of average
domestic prices (for a fixed quantity of money supplied),
– thus causing a proportional appreciation of the domestic
currency (through PPP).

𝑌𝑌𝑈𝑈𝑈𝑈 ↑ → 𝐿𝐿 𝑅𝑅$ , 𝑌𝑌𝑈𝑈𝑈𝑈 ↑ → 𝑃𝑃𝑈𝑈𝑈𝑈 ↓ → 𝐸𝐸$/€ ↓

𝑃𝑃US 𝑀𝑀 𝑆𝑆 US /𝐿𝐿 𝑅𝑅$ , 𝑌𝑌US

𝐸𝐸$/€ = = 𝑆𝑆
𝑃𝑃EU 𝑀𝑀 EU /𝐿𝐿 𝑅𝑅€ , 𝑌𝑌EU
Monetary Approach to Exchange
Rates

• All 3 changes affect money supply or money

demand, and cause prices to adjust so that the
real money supplied matches the real money
demanded, and cause exchange rates to adjust
according to PPP.

𝑃𝑃US 𝑀𝑀 𝑆𝑆 US /𝐿𝐿 𝑅𝑅$ , 𝑌𝑌US

𝐸𝐸$/€ = = 𝑆𝑆
𝑃𝑃EU 𝑀𝑀 EU /𝐿𝐿 𝑅𝑅€ , 𝑌𝑌EU
Note 1: Overshooting
With an increase in the money supply:
• In the long-run model with sticky prices (without PPP), the
level of average prices does not immediately adjust even if
expectations of inflation adjust
– causing the exchange rate to overshoot (causing the
domestic currency to depreciate more than) its long-run
value.
• In the monetary approach (with PPP), the level of average
prices adjusts immediately
– causing the domestic currency to depreciate, but with
no overshooting.
Note 2: Ongoing Inflation
• A one time change in the money supply results in a change in
the level of average prices.
• More realistically, monetary authorities choose a growth rate of
money supply
– A constant growth rate in the money supply results in a
persistent growth rate in prices (persistent inflation) at the
same constant rate, when other factors are constant.
• A change in the growth rate of the money supply results in a
change in the growth rate of prices (inflation).
• Inflation does not affect the productive capacity of the economy
and real income from production in the long run.
– Inflation, however, does affect nominal interest rates (and
hence exchange rates). How?
The Fisher Effect
• The Fisher effect (named after Irving Fisher) describes the
relationship between nominal interest rates and inflation.
– Derive the Fisher effect from the interest parity condition:

R$ − R€
(
=
E e
$/ € − E$ / € )
E$ / €
– If financial markets expect (relative) PPP to hold, then
expected exchange rate changes will equal expected
inflation between countries:

R$ − R€ =
( E e $ / € − E$ / € )= π eUS − π eEU
E$ / €
The Fisher Effect
– Therefore, R$ − R€ = π eUS − π eEU

– The Fisher effect: a rise in the expected domestic

inflation rate causes an equal rise in the interest rate in
the long run, when other factors remain constant.
Example
• According to the Fisher Effect, if the nominal interest rate is
2% higher in Canada than the U.S., what does this imply
about expectations of U.S. inflation and Canadian
inflation?
• What do these inflationary expectations suggest about
future exchange rates if PPP holds?
Example
• Assume that the nominal interest rate in Mexico is 48%
and the interest rate in the United States is 8%. What does
the Fisher effect suggest about the differential in expected
inflation in these two countries?
• Using this information and the PPP theory, describe the
expected nominal return to U.S. investors who invest in
Mexican pesos.
The Fisher Effect and Monetary Policy
• Suppose that the U.S. central bank unexpectedly
increases the growth rate of the money supply at time t0.
• Suppose also that the inflation rate is π in the US before t0
and π + ∆π after this time, but that the European inflation
rate remains at 0%.
• According to the Fisher effect, the interest rate in the U.S.
will adjust to the higher inflation rate.
Long-Run Time Paths of U.S. Economic Variables After
a Permanent Increase in the Growth Rate of the U.S.
Money Supply

𝑅𝑅$ − 𝑅𝑅€ = 𝜋𝜋 𝑒𝑒 US − 𝜋𝜋 𝑒𝑒 EU
The Fisher Effect and Monetary Policy
• The increase in nominal interest rates decreases the real
money demand.
• In order for the money market to maintain equilibrium in the
long run, prices must jump so that
M S US R jumps  L(R,Y) falls
P must jump PUS =
L ( R$ ,YUS )
• In order to maintain PPP, the exchange rate must jump (the
dollar must depreciate) so that
PUS
E must jump E$ / € =
PEU
• Thereafter, the money supply and prices are predicted to
grow at rate π + ∆π and the domestic currency is
predicted to depreciate at the same rate. (E −E $ / €,t )
$ / €, t −1
= π US,t − π EU,t
E$ / €, t −1
Long-Run Time Paths of U.S. Economic Variables After
a Permanent Increase in the Growth Rate of the U.S.
Money Supply
Empirical Evidence on PPP
Law of One Price for Hamburgers?
Shortcomings of PPP
• There is little empirical support for absolute purchasing
power parity.
– The prices of identical commodity baskets, when
converted to a single currency, differ substantially
across countries.
• Relative PPP is more consistent with data, but it also
performs poorly to predict exchange rates.
The Yen/Dollar Exchange Rate and Relative Japan-
U.S. Price Levels, 1980–2012
Shortcomings of PPP
Reasons why PPP may not be accurate: the law of one
price may not hold because of
1. Trade barriers and nontradable products
2. Imperfect competition
3. Differences in measures of average prices for baskets
of goods and services

Note: could also add price stickiness – PPP predictions are

even worse in the short-run than the long-run
Shortcomings of PPP
• Trade barriers and nontradable products
– Transport costs and governmental trade restrictions
make trade expensive and in some cases create
nontradable 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.
– One price need not hold in two markets.
Shortcomings of PPP
• Imperfect competition may result in price discrimination:
“pricing to market.”
– A firm sells the same product for different prices in
different markets to maximize profits, based on
expectations about what consumers are willing to pay.
– Reflects differences in demand conditions
– One price need not hold in two markets.
Shortcomings of PPP
• 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.
– One reason is different consumption patterns - e.g.
more sushi is consumed in Japan than Mexico
– Because measures of groups of goods and services
are different, the measure of their average prices
need not be the same.
– One price need not hold in two markets.
Price Levels Across States
Price Levels and GDP
The Real Exchange Rate
Approach
The Real Exchange Rate Approach to
Exchange Rates
• Because of the shortcomings of PPP, economists have tried to
generalize the monetary approach to PPP to make a better
theory.
• So far, we have discussed nominal exchange rates
– E.g. €1 = $1.3

• Now we will discuss real exchange rates

The Real Exchange Rate Approach to
Exchange Rates
• Consider the price of a MacBook in the US and Europe
– In the US: PUS = $1000
– In Europe: P€ = €700
– The nominal exchange rate is 2 dollars per euro (E$/ € = 2)
– So, Europe’s price in dollars is 2 x 700 = $1400
– In other words, a MacBook in Europe costs as much as 1.4 MacBooks in
the US
– (E$/ € x P€ ) / PUS = 1.4
– 1.4 is the real dollar/euro exchange rate for MacBooks
The Real Exchange Rate Approach to
Exchange Rates
• The real exchange rate is the rate of exchange for goods
and services across countries.
– It is a broad summary measure of the price of one country’s
goods and services relative to another
– For example, it is the dollar price of a European basket of
goods and services (not just MacBooks) relative to the dollar
price of an American basket of goods and services
– It is the number of US baskets that one European basket is
worth

qUS =
( E $/ € × PEU )
EU
PUS
The Real Exchange Rate Approach to
Exchange Rates

qUS =
( E $/ € × PEU )
EU
PUS

– Suppose
 the EU basket costs €100
 the U.S. basket costs $120
 the nominal exchange rate is $1.20 per euro
 then the real exchange rate is 1 U.S. basket per 1
EU basket (qus/eu = 1)
$1.20 × 100 120
𝑞𝑞𝑈𝑈𝑈𝑈/𝐸𝐸𝐸𝐸 = = =1
– PPP holds in this case $120 120
The Real Exchange Rate Approach to
Exchange Rates
qUS =
( E $/ € × PEU )
EU
PUS

– Suppose
 the EU basket costs €100
 the U.S. basket costs $130
 the nominal exchange rate is $1.10 per euro

– What is the real exchange rate? 𝑞𝑞 =

$1.10 × 100 110
= = 0.85
𝑈𝑈𝑈𝑈/𝐸𝐸𝐸𝐸
$130 130
– qus/eu = 0.85
– The dollar price of the European basket is 85% of the
American basket (roughly dollar prices of
goods/services are cheaper in Europe)
The Real Exchange Rate Approach to
Exchange Rates
– A rise in the real dollar/euro exchange rate is called a real
depreciation of the dollar against the euro
– If the real exchange rate rises from 0.8 to 0.9, the dollar
price of the European basket became relatively more
expensive
– A real depreciation of the value of U.S. products means a
fall in a dollar′s purchasing power of EU products relative to
a dollar′s purchasing power of U.S. products.
 This implies that U.S. goods become less expensive and
less valuable relative to EU goods.

– Real appreciation is the just the opposite (a fall in qus/eu)

The Real Exchange Rate Approach to
Exchange Rates
Dollar Euro America’s Europe’s exports
exports
q$/€↑ Real Depreciation Real Appreciation Less expensive More expensive
q$/€↓ Real Appreciation Real Depreciation More expensive Less expensive

qUS =
( E $/ € × PEU )
EU
PUS

Dollar Euro America’s exports Europe’s exports

𝐸𝐸$/€ ↑ Nominal Nominal Less expensive More expensive
Depreciation Appreciation
𝐸𝐸$/€ ↓ Nominal Nominal More expensive Less expensive
Appreciation Depreciation
The Real Exchange Rate Approach to
Exchange Rates
• According to PPP, (nominal) exchange rates are
determined by relative average prices:
PUS
E$ / € =
PEU
• According to the more general real exchange rate
approach, (nominal) exchange rates may also be
influenced by the real exchange rate:
PUS
E$=
/€ qUS ×
EU
PEU
• What influences the real exchange rate?
The Real Exchange Rate Approach to
Exchange Rates
• A change in relative demand of U.S. products
– An increase in relative demand of U.S. products causes
the price of U.S. goods relative to the price of European
goods to rise.
– PUS rises relative to 𝐸𝐸$/€ × 𝑃𝑃EU
– Real appreciation of the value of U.S. goods (qus/eu down)

– One European basket is worth less US baskets

qUS =
( E $/ € × PEU )
EU
PUS
The Real Exchange Rate Approach to
Exchange Rates
• A change in relative supply of U.S. products
– i.e. more output Y
– An increase in relative supply of U.S. products (caused by
an increase in U.S. productivity) causes the price of U.S.
goods relative to the price of European goods to fall.
– PUS falls relative to 𝐸𝐸$/€ × 𝑃𝑃EU
– Real depreciation of the value of U.S. goods (qus/eu up)

– One European basket is worth more US baskets

qUS =
( E $/ € × PEU )
EU
PUS
Determination of the Long-Run Real
Exchange Rate
The Real Exchange Rate Approach to
Exchange Rates
• The real exchange rate is a more general approach to
explain exchange rates. Both monetary factors and real
factors influence nominal exchange rates:
1a. Increases in relative money supply lead to temporary
inflation (increase in P)
1b. Increases in relative money supply growth rates
lead to persistent inflation (increases P and R).
2a. Increases in relative demand of domestic products
lead to a real appreciation (fall in q).
2b. Increases in relative supply of domestic products
lead to a real depreciation (increase in q, fall in P).
𝑃𝑃US 𝑀𝑀 𝑆𝑆 US /𝐿𝐿 𝑅𝑅$ , 𝑌𝑌US
𝐸𝐸$/€ = 𝑞𝑞US × = 𝑞𝑞US × 𝑆𝑆
EU 𝑃𝑃EU EU 𝑀𝑀 EU /𝐿𝐿 𝑅𝑅€ , 𝑌𝑌EU
The Real Exchange Rate Approach to
Exchange Rates
• What are the effects on the nominal exchange rate?
𝑃𝑃US 𝑀𝑀 𝑆𝑆 US /𝐿𝐿 𝑅𝑅$ , 𝑌𝑌US
𝐸𝐸$/€ = 𝑞𝑞US × = 𝑞𝑞US × 𝑆𝑆
EU 𝑃𝑃EU EU 𝑀𝑀 EU /𝐿𝐿 𝑅𝑅€ , 𝑌𝑌EU

• When only monetary factors change, 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.
– With an increase in relative demand of domestic products,
the real exchange rate falls and determines nominal
exchange rates.
– With an increase in relative supply of domestic products, the
situation is more complex.
The Real Exchange Rate Approach to
Exchange Rates
• With an increase in the relative supply of domestic products (i.e.
Y goes up), the real exchange rate adjusts to make the
price/cost of domestic goods depreciate
– But the increased output increases the real money demand
in the domestic economy:
M SUS
PUS =
L ( R$ ,YUS )

– Thus 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:
PUS
E$=
/€ qUS ×
EU
PEU
? ↑ ↓
The Real Exchange Rate Approach to
Exchange Rates
• When economic changes are influenced only by monetary
factors, nominal exchange rates are determined by relative
PPP in the long run.
• When economic changes are caused by factors that affect
real output, exchange rates are not determined by PPP
only, but are also influenced by the real exchange rate.
Effects of Money Market and Output Market
Changes on the Long-Run Nominal Dollar/Euro
Exchange Rate, E$/€
Effect on the Long-Run Nominal
Change
Dollar/Euro Exchange Rate, E$/€

Money market Blank

1. Increase in U.S. money supply level Proportional increase (nominal

depreciation of $)
2. Increase in U.S. money supply growth rate Increase (nominal depreciation of $)

Output market Blank

1. Increase in demand for U.S. output Decrease (nominal appreciation of $)

2. Output supply increase in the United States Ambiguous

Updated Fisher Effect
• A more general equation of differences in nominal interest rates
across countries can be derived from
(q e
− qUS/EU ) (
 E e $ / € − E$ / € )  −
US/EU
= 
qUS/EU  E$ / € 
(π e
US − π eEU )
 

R$ − R€
(E
=
e
$/ € − E$ / € )
E$ / €
(q e
− qUS/EU )+
=
R$ − R€
US/EU

qUS/EU
(π e
US − π 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, and
– the difference in expected inflation rates between the domestic
economy and the foreign economy.
Real Interest Parity
• Real interest rates are inflation-adjusted interest rates:
r e= R − π e
where π represents the expected inflation rate and
e

R represents a measure of nominal interest rates.

• Real interest rates are measured in terms of real output:

– the quantity of goods and services that savers can
purchase when their assets pay interest
• What are the predicted differences in real interest rates
across countries?
Real Interest Parity
• Real interest rate differentials are derived from
(
r eUS − r eEU = R$ − π eUS − R€ − π eEU ) ( )
(q e
− qUS/EU )+
=
R$ − R€
US/EU

qUS/EU
(π e
US − π eEU )
r e
−r e
(
=
q e
US/EU − qUS/EU )
US EU
qUS/EU
• The last equation is called real interest parity.
– It says that differences in real interest rates between
countries are equal to the expected change in the
value of goods and services between countries.
Summary
1. The law of one price says that the same good in
different competitive markets must sell for the same
price, when transportation costs and barriers between
markets are not important.
2. Purchasing power parity applies the law of one price
for all goods and services among all countries.
– Absolute PPP says that currencies of two countries
have the same purchasing power.
– Relative PPP says that changes in the nominal
exchange rate between two countries equals the
difference in the inflation rates between the two
countries.
Summary
3. The monetary approach to exchange rates uses PPP
and the supply and demand of real monetary assets.
– Changes in the growth rate of the money supply
influence inflation and exchange rates.
– Expectations about inflation influence the exchange
rate.
– The Fisher effect shows that differences in nominal
interest rates are equal to differences in inflation rates.
4. Empirical support for PPP is weak.
– Trade barriers, nontradable products, imperfect
competition and differences in price measures may
cause the empirical shortcomings of PPP.
Summary
5. The real exchange rate approach to exchange rates
generalizes the monetary approach.
– It defines the real exchange rate as the value/price/cost
of domestic products relative to foreign products.
– It predicts that changes in relative demand and relative
supply of products influence real and nominal
exchange rates.
– Interest rate differences are explained by a more
general concept: expected changes in the value of
domestic products relative to the value of foreign
products plus the difference of inflation rates between
the domestic and foreign economies.
Summary
6. Real interest rates are inflation-adjusted interest rates,
and show how much purchasing power savers gain and
borrowers give up.
7. Real interest parity shows that differences in real interest
rates between countries equal expected changes in the
real value of goods and services between countries.