ch3_international econ.pdf

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Exchange Rates and Prices in the Long Run

2 Money, Prices, and

Exchange Rates in the Long Run

3 The Monetary

A h

EXCHANGE RATES I: THE MONETARY

APPROACH IN THE Approach

4 Money, Interest, and

Prices in the Long Run5

Monetary Regimes and Exchange Rate

Regimes6

Conclusions

LONG RUN

Chapter Outline

1. Exchange Rates and Prices in the Long Run2. Money, Prices and Exchange Rates in the Long

RunRun3. The Monetary Approach4. Money, Interest, and Prices in the Long Run5. Monetary Regimes and Exchange Rate Regimes

Today: topic 1

2 of 93 2008 Worth Publishers International Economics Feenstra/Taylor

Today: topic 1

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Chapter outline

Examples of questions we will address in this lecture:

Is the Chinese Renminbi undervalued? How large is Chinese GDP relative to US GDP? If there is more inflation in the US than in the Euro

zone, how should this affect the $/ exchange


grate in the long run?

1. Exchange Rates and Prices in the Long Run

The notion of arbitrage Chapter 2: applied there to currencies and interest rates Chapter 2: applied there to currencies and interest rates Chapter 3: applied here to goods

The foundation of this theory is the fundamental arbitrage principle known as the law of one price (LOOP)


(LOOP).

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The Law of One Price

Key assumption: frictionless trade No transaction costs No barriers to tradeNo barriers to trade Identical goods in each location

Law of One Price (LOOP):

The prices of a given good must be equal in all locations when expressed in a common currency


locations when expressed in a common currency. Otherwise, there would be a profit opportunity from

buying low and selling high (arbitrage).

The Law of One Price

Is the LOOP true in the data? 2009, in US $

Source: Economist Intelligence Unit.

Abidjan Amsterdam Beijing HongKong Geneva TehranDomesticcleaning(1hr) 4.34 15.71 4.39 12.9 25.23 3.52

Oranges(1kg) 1.3 2.57 2.87 2.26 2.99 1.81


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Measuring International Price Differences

We would like to measure the extent to which goods are more expensive in one country than in another. Look at basket of goods.g

Real exchange rate


Analogous to nominal exchange rate but note keydifference: goods rather than currencies.

The Real Exchange Rate

Real exchange rate appreciation, depreciation


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The Real Exchange Rate

How is the real exchange rate measured?

Direct comparison of prices of goods Direct comparison of prices of goods

As an index, whose variations are given by


Multilateral effective exchange rate

Real Exchange Rate in the Data

How does the real exchange rate behave in the data?data?

This depends a lot on the countries one looks at and the time period.


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Real Exchange Rate in the Data Between advanced economies, large real exchange rate

fluctuations in the short run, but q close to 1 in the medium to long run (absolute PPP).


Real Exchange Rate in the Data

Absolute PPP:

Relative PPP:


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What Explains Deviations from PPP?

Transaction costs

Nontraded goods


Price stickiness

What Explains Deviations from PPP?

Month-to-Month Variability of the Dollar/DM Exchange Rate and of the U.S./German Price-Level Ratio, 1974-2001


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How Fast is Convergence to PPP?

Two measures: Speed of convergence: how fast deviations from PPP

disappear over timedisappear over time 15% per year.

Half-life: how long it takes for half of the deviations from PPP to disappear (about four years).


These estimates are useful for forecasting how long exchange rate adjustments will take.

Persistent deviations from PPP

Prices tend to be higher in rich countries


Balassa-Samuelson effect.

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Balassa-Samuelson Effect

Bela Balassa (1928-1991)Paul Samuelson (1915-2009)


The Big Mac Index

For over 20 years The Economist newspaper has compared Big Mac prices across countries.

The Economist asked correspondents around the world to visit McDonalds and get prices of a Big Mac, then compute price relative to the U.S.

Does this test PPP or LOOP?


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The Big Mac Index

Big Mac index = qBig Mac 1 = E$/local currencyPlocal

Big Mac

PUSBig Mac 1

The % deviation (+/) from the US price measures the over/under valuation of the local currency based on the burger basket. Updated every year:

http://www.economist.com/markets/Bigmac/

US


p g In 2004 they tried the same exercise with another

global homogeneous product: the Starbucks tall latte.

Big Max Index (Feb. 4, 09)


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The Big Mac Index

Deviations from PPP and economic development


Lets recap Real exchange rate:

Absolute PPP: q=1 (relative PPP: q constant) Absolute PPP applies in the medium to long run

between countries of same level of


development. Persistent deviations from PPP between

countries with different levels of development (Balassa-Samuelson).

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Applications of PPP and exchange rates

Three applications:

I fl ti d i l h t d i ti Inflation and nominal exchange rate depreciation Measuring under- and overvaluations Comparing GDP across countries


Application 1: Inflation and Nominal Exchange Rates

Consider 2 countries, A and B

Inflation higher in country B than in country A, g y y ,what does happen to the nominal exchange rate EB/A?


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Application 1: Inflation and Nominal Exchange Rates

Real exchange rate not affected by inflation differentials in the long run


Application 2: Measuring Overvaluations and Undervaluations

By how much was the Chinese currency undervalued relative to the dollar in 2000?


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Application 2: Measuring Overvaluations and Undervaluations

In 2000, model prediction: equilibrium q = 0.319 versus actual q = 0.231 the Chinese c rrenc as nder al ed b 38% the Chinese currency was undervalued by 38%

Caveats


Application 3: Comparing GDP Across Countries

In 2008, US GDP = bn$ 14,441

US GDP per capita= $47 440US GDP per capita= $47,440

Chinese GDP = bn$ 4,327 (30% of US level)Chinese GDP per capita= $3,259 (6.9% of US level)

( t k t h t )


(at market exchange rate)

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But real exchange rate

q =0 546qC/US =0.546

So PPP-adjusted Chinese GDP

bn$ 4,327/ qC/US =bn$ 7,926 (55% of US level)


Per capita: 12.6% of US level


Ratio of Chinese GDP to US GDP

0.6

0 2

0.3

0.4

0.5

market exchange rate

PPP-adjusted


0

0.1

0.2

2000 2001 2002 2003 2004 2005 2006 2007 2008

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US GDP per capita as a multiple of Burundis & Bangladeshs

150

200

250

300

350

market rate

PPP adjusted


0

50

100

Burundi Bangladesh

ch3_international econ.pdf

Documents

nominal exchange rate

exchange rate regimestoday

g real exchange rate7

rates chapter

long run2 money

long run3

long runrun3

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