• The law of one price and the PPP theory

• The monetary model of the long-run exchange rate

determination

• The empirical evidence on the PPP theory

Price Levels and the Exchange • The generalized model of the long-run exchange rate
determination
Rate in the Long Run
• The international price differences and real interest
parity

Objective The Law of One Price

 This lesson analyzes the determination of the  The law of one price: Under the assumption of perfect
exchange rate in the long-run, taking into account competition and if there are no transportation costs and trade
both monetary and non-monetary factors in the barriers, the same good must sold for the same price in
determination of the exchange rate different markets.
 Example:
 A T-shirt in Vietnam costs 220000 VND.
 The same T-shirt is priced at 10 USD.
 Suppose the exchange rate is 1 USD = 22000 VND.
➔ The prices of the T-shirt in Vietnam and US are the same when
they are measured in the same currency.
The Law of One Price Purchasing Power Parity (PPP)
 According to the law of one price, if there are  The PPP theory states that the exchange rate must be
differences in the prices of the same goods in different equal to the ratio of the domestic and foreign price levels.
markets, arbitrage will take place and eventually  A decline in the purchasing power of the domestic
equalize the prices across markets. currency is associated with a proportional depreciation of
the domestic currency. By contrast, an increase in the
 Question 1: What would happen if the price of the T- purchasing power of the domestic currency results in a
shirt is 240000 VND in Vietnam? proportional appreciation of the domestic currency.
 Question 2: What would happen if the price the T-  The PPP theory comes in two forms: absolute PPP and
shirt is 11 USD in the US? relative PPP.

The Law of One Price Purchasing Power Parity (PPP)

 The law of one price establishes a relation between  The absolute PPP establishes the relation between domestic
domestic and foreign prices and the exchange rate, as
price, foreign price and the exchange rate in the absolute term
follows:
P = E×P* P = E×P* or
Here P is the domestic price of a certain good,
E = P/ P*
P* is the foreign price of the same good,
E is the exchange rate P is the domestic price level;

P* is the foreign price level;

E is the exchange rate (direct quotation)

Purchasing Power Parity (PPP) Purchasing Power Parity (PPP)
 Example:  The relative PPP theory can be written as follows:
 The price of the basket of goods is 23.0 million VND in Vietnam.
The price of the same basket of goods is 1000 USD in the US. ∆E/E = π-π* or e = π-π*
What would be the exchange rate between VND and USD if PPP Here π and π* are domestic and foreign inflation
holds in practice?
rates respectively
 The absolute PPP theory does not always hold true in
practice due to the existence of transportation costs and trade π = ∆ P/P
barriers π* = ∆P*/P*

The Law of one price and the PPP

Purchasing Power Parity (PPP)
 The law of one price and the PPP establish the relation between domestic

 The relative PPP theory is derived from the absolute PPP. prices, foreign prices and the exchange rate, which is brought about by the

arbitrage force.
 The relative PPP theory asserts that the percentage change in
 Different from the law of one price, the PPP theory applies to the price
the exchange rate must be equal to the difference between the
level, i.e. the prices of a basket of goods, instead the price of a single
percentage changes in the domestic and foreign price levels.
commodity.

 The PPP theory may hold in the reality even if the law of one price fails to

hold for a single commodity.

 • The law of one price and the PPP theory
Monetary approach to the exchange rate
• The monetary model of the long-run exchange
rate determination  The monetary model consist of three equations:

 the PPP theory,

• The empirical evidence on the PPP theory
 The equilibrium condition in the domestic money
• The generalized model of the long-run exchange rate market and
determination
 the equilibrium condition in the foreign money market
• The international price differences and real interest
parity

Monetary approach to the exchange rate Monetary approach to the exchange rate

 The monetary model of the exchange rate (flexible  The PPP condition is assumed to hold in the foreign exchange
market
price model) is a combination of the PPP theory
 E = P/P*
and the theory of money demand and supply.
 The domestic and foreign price levels are determined by the
 The monetary model is based on the assumption of equilibrium condition in the money markets under the
 full employment and assumption of the standard monetary demand function.
 P = MS/L(Y,R)
 the flexibility of prices and wages, and
 P* = MS*/L(Y*,R*)
 a long-run model of the exchange rate determination.
 Monetary approach to the exchange rate
Monetary approach to the exchange rate
▪ Money supply: a permanent rise in the domestic money
supply
 In the monetary model of the exchange rate,  causes a proportional increase in the domestic price level,
 causing a proportional depreciation in the domestic currency
 the changes in economic policies or economic environment (through PPP).

lead to the changes in the money supply and demand ▪ Interest rates: a rise in the domestic interest rate
 lowers domestic money demand,
 ➔ the price levels adjust to maintain the equilibrium in  increasing the domestic price level,
 causing a proportional depreciation of the domestic currency
money markets. (through PPP).
▪ Output level: a rise in the domestic output level
 The exchange rate adjusts in line with the price levels to  raises domestic money demand,
 decreasing the domestic price level,
maintain the PPP.
 causing a proportional appreciation of the domestic currency
(through PPP).

Monetary approach to the exchange rate Ongoing inflation, the interest rate and the PPP

 The long-run exchange rate is affected by monetary  A continuous rise in the domestic supply of money leads to a

developments and output: continuous and proportional rise in the domestic price level.

 The supply of money  The ongoing inflation affects public expectation on prices, thus
having an impact on the interest rate.
 The interest rate
 If the PPP is hold in the long-run, the difference between the
 Output
domestic and foreign interest rates will be equal to the difference
between the expected inflation rates at home and abroad.
Ongoing inflation, the interest rate and the PPP Fisher effect

 From the UIP: R = R*+(Ee-E)/E ; and  The relationship between the exchange rate and interest
rate differs in the short-run and long-run.
 From the PPP: (Ee-E)/E = πe – π*e
 In the short-run, prices are sticky and an increase in the
 We can derive: R - R* = πe – π*e interest rate is associated with an appreciation of domestic
currency.
Here R and R* denote for domestic and foreign interest rates; πe and π*e
are the expected inflation rates at home and abroad  In the long-run, prices are flexible and an increase in the
interest rate is associated with a higher price level and a
depreciation of domestic currency.

Fisher effect • The law of one price and the PPP theory

• The monetary model of the long-run exchange rate

determination
 The Fisher effect theory establishes a long-run
relationship between inflation and interest rates. • The empirical evidence on the PPP theory
 It states that, all else equal, an increase in the expected
• The generalized model of the long-run exchange rate
inflation leads to a proportional rise in the interest determination
rate.
• The international price differences and real interest
parity
Empirical on the PPP Explanation for the poor performance of the PPP
 The existence of trade barriers and transportation costs
 The PPP does not explain well the movement of the exchange rate and causes a considerable price divergence between countries.
the relationship between the exchange rate and price level in the short-
 The existence of imperfect competition (monopoly and
run
oligopoly), in combination with trade barriers and
 The absolute PPP: the actual exchange rate is very different from the transportation costs further weaken the price links across
rate computed from the PPP, particularly in the short-run. countries.
 The relative PPP: the actual changes in the exchange rate and
 The price levels and inflation are measured using difference
inflation also differ from that predicted by the PPP, especially in the
short-run.
baskets of commodities, making it difficult for a cross-country
comparison.
 The relative PPP can perform better the absolute PPP, and it can
explain better the movement of the exchange rate in the long-run. The  The price levels cover not only traded goods, but also non-
PPP also perform better for those countries that have a large trading or traded goods, which are irrelevant for the law of one price and
have a geographical proximity. the PPP.

Empirical on the PPP Explanation for the poor performance of the PPP

Trade barriers and transportation costs

 Transportation costs and trade barriers create the
difference in the price of goods and services between
countries.
 Transportation costs and trade barriers weakens the law of
one price and the PPP theory (particularly the absolute
PPP theory)
Explanation for the poor performance of the PPP
Non-traded goods Explanation for the poor performance of the PPP
 Non-traded goods are those commodities and services that
cannot be traded between countries because of their Different baskets of goods and services and
characteristics, high transportation costs or trade barriers. Statistical errors
 The prices of non-traded goods are determined by the demand  The reference basket of goods and services used to
and supply at the home market, and they are not linked to the compute the price level varies from countries to
international price.
countries, reflecting the difference in consumption
 The existence of non-tradables weakens the law of one price and demand between countries.
makes it difficult to compare the price between countries.
 Non-tradables constitute a large proportion in the reference
 These statistical problems create the difficulty in
basket of commodities and have a considerable influence on the comparing the price levels and testing the PPP theory.
overall price level.

Explanation for the poor performance of the PPP Explanation for the poor performance of the PPP
Other explanations
Imperfect competition
 Short-run price stickiness: due to the short-run price
 Monopolistic or oligopolistic firms can price rigidity, the departure of the actual exchange rate from
differently in different market the PPP exchange rate can be larger in the short-run.
 The differentiated pricing leads to a violation of the  Intervention in the FX market: The violation of the
law of one price. PPP is found larger and more frequent for those
countries with a fixed exchange rate.
 • The law of one price and the PPP theory Real exchange rate
• The monetary model of the long-run exchange rate • Example:
determination
qUS/EU = (E$/€ x PEU)/PUS

• The empirical evidence on the PPP theory If the EU basket costs €100, the US basket costs
$100 and the nominal exchange rate is $1.0 per euro,
• The generalized model of the long-run exchange then the real exchange rate is 1 US basket per EU
rate determination basket

• The international price differences and real interest

parity

Real exchange rate Real exchange rate

 Real exchange rate is the relative price of goods and  Real appreciation
services between countries.
 An increase in domestic inflation leads to a fall in the
 The real exchange rate is the nominal exchange rate
adjusted for the change in the price levels at home and value of domestic currency.
abroad.  The real exchange rate falls, indicating the appreciation
 The real exchange rate are defined as follows: of domestic currency in real terms (the domestic goods
become more expensive and more valuable relative
q = (E×P*)/P
to the foreign goods)
 P and P* are the price levels at home and abroad; Q and E are the
real and nominal exchange rate respectively.
Real exchange rate
Long-term equilibrium real exchange rate
 Real depreciation:
 A decrease in domestic inflation leads to an increase in
the real exchange rate,
 The real exchange rate increases, indicating the real
depreciation of domestic currency (the domestic goods
become less expensive and less valuable relative to
the foreign goods)

Real and nominal exchange rates in long-term

Long-term equilibrium real exchange rate equilibrium
 The long-term real equilibrium exchange rate depends on
 The nominal exchange rate depends not only on the
the demand and supply at home and abroad.
domestic and foreign price levels, but also on the
 Change in relative demand: a relative increase in the
world demand for domestic goods and services leads to an change in real exchange rate.
increase in domestic prices relative to foreign price) and a
real appreciation of domestic currency. E = q×(P/P*)
 Change in relative output supply: an increase in
domestic output leads to a fall in domestic prices and a
real depreciation of domestic currency.
Real and nominal exchange rates in long-term The determination of the long-run nominal
equilibrium exchange rate
 Change in relative output demand:
 Given a level of the real exchange rate, the changes in  An increase in the world relative demand for domestic
money supply and money demand affect the goods leads to a real appreciation of domestic currency, and
nominal exchange rate as predicted from the monetary given the national price level unchanged, there is also a
nominal appreciation of domestic currency.
theory.
 Change in relative output supply:
 Non-monetary factors have impacts on the exchange  An increase in relative domestic supply lowers the relative
rate through their impacts on the real exchange rate domestic prices and causes domestic currency to depreciate
in real terms. The impact on nominal exchange rate is
ambiguous.

The determination of the long-run nominal

• The Law of one price and the PPP theory
exchange rate
• The monetary model of the long-run exchange rate
 Shifts in relative money supply levels: determination
 An increase in domestic money supply leads to a
proportional increase in domestic prices and a • The empirical evidence on the PPP theory
proportional depreciation of domestic currency.
• The generalized model of the long-run exchange rate
 Shifts in relative money supply growth rates: determination
 permanent increase in the growth rate of domestic
money supply raises domestic inflation and domestic • The international price differences and real
interest parity
currency depreciates to the same extent.
The PPP and UIP Real interest parity
 Combing the PPP and UIP  Real interest parity: the difference between domestic
R – R* = (Qe-Q)/Q + (πe-π*e) and foreign real interest rate is equal to the expected
Where πe and π*e are the expected inflation at home and
rea depreciation rate of domestic currency.
abroad
 This equality shows that the difference in the interest rates
r – r* = (Qe-Q)/Q
is equal to the expected real depreciation of domestic
currency plus the difference between the expected
inflation rates at home and abroad.

Real interest parity

 Real interest rate: the rate of return in terms of
countries‘ output.
 The real interest rate is the nominal interest rate
minus the expected inflation rate:

re = R – πe