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Exchange Rate Determination(2)Trade Approach

Dr. J. D. Han

King’s College

U.W. O.

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1. Overview: International Trade’s perspectiveLinks FOREX Rates to the relative price levels of the two countries in International Trade.

1) At equilibrium of International Trade

E = P / Pf at equilibrium

-> P = Pf times E

-> One Price for One Goods (where ever you go)

-> No more incentive to move/trade merchandise

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2) At Disequilibrium

“Changes in relative price level leads to changes in FOREX rates”

If P domestic / P foreign > actual S, ->then exports fall and imports rise. ->Current Account and BP deteriorate. ->Excess Demand for FOREX occurs. -> upward pressure on E ->E may rise So that P = S Pf

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*PPP leads eventually to 2 other theories: What changes the Price Levels?

1) Nominal Factor such as Money Supply “Monetary Approach”

2) Real Factors such as Demand and Supply of Trade Goods(‘Tradables’)

Excess Supply lowers P domestic <-Excess Supply can happen due to i) innovation on the

supply side and/or ii) suppressed demand-> “Real Factor Analysis of FOREX Rate”

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2. Purchasing Power Parity 1) It says: “Under a certain set of conditions, Exchange Rate is determined in such a way

that a unit of a certain currency should, through the conversion using the exchange rate, fetch the same amount of goods in the foreign country as it would in the domestic countries”;

“ A currency should have the same purchasing power everywhere in the world.”

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2) Putting it differenly, “ Law of

One Price for One Good”• In the long-run equilibrium with free flows

of merchandise(free trade), a merchandise should have the same price, in a currency, everywhere in the world through arbitrage of international trade.

<- Note the condition for PPP or LOPOG.

3) Equilibrium FOREX rate by PPP

• The hypothetical ‘PPP’ dictated FOREX Rate is such that at it should enable you to buy the same amount of goods with the same (starting) money where ever you may go.

• Of course, the actual FOREX rate could be temporarily different from this equilibrium FOREX rate.

• If the merchandise is not freely traded, then PPP does not work.

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3. Example: “BigMac Index”

If PPP works,

• In Canada, $2 -> a BigMac

• $2 should exchange for X Yuan in China,

so that in China, X Yuan -> a BigMac

• $2 should exchange for Y Won in Korea, so that in Korea, Y Won -> a BigMac

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What should be the ‘correct’ (equilibrium) FOREX rate?

Country A Big Mac Price

PPP FOREX rate(Equilibrium)

Actual FOREX Rate

Gap

Canada $2

China 10 Yuan 10 Yuan/ $2=

6 Yuan/ $1 U.S. dollar is overvalued/Chinese Yuan is undervalued.

Korea 2000 Won 1000 Won/$1

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4. Under what set of conditions does Purchasing Power Parity hold?

• No changes in Real Factors, or Supply/ Demand for domestic/foreign goods; “other things being equal”(ceteris paribus)

• In the Long Run equilibrium situation; • For tradables; not for non-tradables • Works best with free trade or no barrier to trade;• Price Measurement should be correct.

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* Empirical Evidence of PPP

(1) ‘Big Mac Index’: Mixed

(2) Non-Tradable Goods: Not working

(3) Tradable Goods: working well

(4) All goods: Mixed

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(1) A widely cited evidence for/against PPP: “Big Mac Index”

FOREX rates calculated on the basis of the local currency prices of a Big Mac across countries

PPP: A Big Mac Meal might cost the same after currency conversion whatever country it might be sold in and in whatever currency it might be sold in.

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• Updated Big Mac Index; http://www.licenseenews.com/news/news188.html

• Mixed Evidence for/against PPP

The actual FOREX rates differ significantly from the Big Mac Index

-Why? Recall : PPP presupposes Free Trade.

PPP works for Tradable Goods only, and in the long-run only

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*In contrast, there is no reason why a price of non-tradable good should have the same price in two different countries unless the production factors are completely mobile between the two countries.

Eg) A steak dinner costs U.S. $50 in New York. An equally good steak costs _____ Yuan in China.

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5. Two Versions of PPP

• Absolute PPP

“Level”

P = S Pf

S = P/Pf

S Pf / P = 1

• Relative PPP

“Percentage Changes”

Δ%P = Δ% S + Δ%Pf

Δ% S = Δ%P - Δ%Pf

= π – πf

According to the above, FOREX rates changes

• In response to

Changes in the Relative Price Level of Domestic to Foreign Countries.

-> S rises against the country who price level goes up.

• In response to Inflation Differential between Domestic and Foreign Countries.

-> S goes up for the country with a higher rate of inflation

-> A Higher inflation country experiences Depreciation of its own Currency.

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6. Visual Image of PPP in time-series data

• S Pf /P = 1 •If P/ Pf looks like this,

S must move this way if PPP holds.

time

If PPP holds, then in the data we should see:

In reality,

• The shape of the time series data of S or FOREX may be different as the Purchasing Power Parity does not perfectly work.

-> What will explain the differences?

Something else works along with PPP.

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