Chapter 16

Price Levels
and the Exchange
Rate in the Long
Run
 Preview

• Law of one price

• Purchasing power parity
• Long-run model of exchange rates: monetary
approach (based on absolute version of PPP)
• Relationship between interest rates and inflation:
Fisher effect
• Shortcomings of purchasing power parity
• Long-run model of exchange rates: real exchange rate
approach (based on relative version of PPP)

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 Models of Exchange Rate Behavior

• In the last chapter we developed a short and 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.
• The long-run models are not intended to be completely
realistic descriptions about how exchange rates behave
– How market participants may form expectations about future
exchange rates and how exchange rates tend to move over long
periods.

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 Law of One Price

• The law of one price says that the same good in different
competitive markets must sell for the same price (using a
common currency), when transportation costs and barriers
between markets are not important.
– Why? The reason is an arbitrage which should eliminate the price
differentials among different markets.

• Consider a pizza in Seattle and in Vancouver.

PUS = (EUS/Can) x (PCan)
PUS is price of pizza in Seattle

PCan is price of pizza in Vancouver

EUS/Can is U.S. dollar/Canadian dollar exchange rate

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 Purchasing Power Parity
• Purchasing power parity is the application of the
law of one price across countries for representative
baskets of goods and services:

PUS = (EUS/Can) x (PCan)

PUS is price level in the U.S.

PCan is price level in Canada
EUS/Can is U.S. dollar/Canadian dollar exchange rate

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 Purchasing Power Parity

• Purchasing power parity (PPP) implies that the

exchange rate is determined by price levels:

EUS/Can = PUS/PCan
– If the price level in the U.S. is US$200 per basket, while the
price level in Canada is C$400 per basket, PPP implies that the
C$/US$ exchange rate should be C$400/US$200 = C$2/US$1.

– 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.

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 Purchasing Power Parity

• 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.
E$/€ = PUS/PEU

• Relative PPP: changes in exchange rates equal

changes in prices (inflation) between two periods:
(E$/€,t – E$/€, t –1)/E$/€, t –1 = US, t – EU, t
where t = inflation rate from period t –1 to t

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 Monetary Approach to Exchange Rates

• Monetary approach to the exchange rate is based on

the absolute version of PPP and uses monetary factors
to predict how exchange rates adjust in the long run
– It predicts that levels of average prices across countries adjust
so that the quantity of real monetary assets supplied will equal
the quantity of real monetary assets demanded:

PEU = MsEU/L (R€, YEU)

• According to the monetary approach:
– The exchange rate is determined in the long run by price levels,
which are determined by the relative supply and demand of real
monetary assets in money markets across countries.

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 Predictions of Monetary Approach
to Exchange Rates
• The fundamental equations of the monetary approach
PUS = MsUS/L (R$, YUS)

PEU = MsEU/L (R€, YEU)

E$/€ = PUS/PEU

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.

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 Predictions of Monetary Approach
to Exchange Rates
• The fundamental equations of the monetary approach
PUS = MsUS/L (R$, YUS)

PEU = MsEU/L (R€, YEU)

E$/€ = PUS/PEU

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).

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 Predictions of Monetary Approach
to Exchange Rates
• The fundamental equations of the monetary approach
PUS = MsUS/L (R$, YUS)

PEU = MsEU/L (R€, YEU)

E$/€ = PUS/PEU

3. Output level: a rise in the domestic level of 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).

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 Predictions of Monetary Approach
to Exchange Rates

• A change in the money supply results in a change in

the level of average prices.
• A change in the growth rate of the money supply
results in a change in the growth rate of prices
(inflation).
– 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.
– 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. How?

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 The Fisher Effect

• The Fisher effect (named after Irving Fisher) describes

the relation between nominal interest rates and
inflation.
– Derive the Fisher effect from the interest parity condition:
R$ – R€ = (Ee$/€ – E$/€)/E$/€
– If financial markets expect (relative) PPP to hold, then expected
exchange rate changes will equal expected inflation between
countries: (Ee$/€ – E$/€)/E$/€ = eUS – eEU

– Therefore, R$ – R€ = eUS – eEU

– The Fisher effect: a rise in the domestic inflation rate causes an
equal rise in the interest rate on deposits of domestic currency
in the long run, when other factors remain constant.

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 Fig. 16-1: Long-Run Time Paths of U.S. Economic
Variables After a Permanent Increase in the Growth
Rate of the U.S. Money Supply

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  in the US before t0 and  + 
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.
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 Fig. 16-1: Long-Run Time Paths of U.S. Economic
Variables After a Permanent Increase in the Growth
Rate of the U.S. Money Supply

The increase in nominal interest rates decreases the demand of real

monetary assets. In order for the money market to maintain equilibrium in
the long run, prices must jump so that: PUS = MsUS/L (R$, YUS)
In order to maintain PPP, the exchange rate must jump (the dollar must
depreciate) so that: E$/€ = PUS/PEU
Thereafter, the money supply and prices are predicted to grow at rate  + 
and the domestic currency is predicted to depreciate at the same rate.
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 The Role of Inflation and
Expectations
In the short-run model without PPP:
• An increase in interest rate is caused by lower supply of real money
balances or by higher demand for real money balances. The reason
is that the price level is fixed in the short run.
• This increase in interest rate is associated with lower expected
inflation and a long-run appreciation, so the currency appreciates
immediately.
In the long-run model based on PPP:
• An increase in interest rate is caused by higher expected inflation
(through the Fisher effect) which is caused by higher expected
money growth rate in the future.
• A higher expected inflation leads to an immediate currency
depreciation.

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 The Role of Inflation and
Expectations
• In order to examine the relation between interest
rates and exchange rates, it is important to know:
1. What factors caused the interest rate to move
– change of a money supply level versus change of a money
supply growth rate
– one-time increase of money supply level does not affect
expected inflation while an increase of a money supply growth
rate does affect (increase) expected inflation
2. What time horizon do we assume
– short-run horizon implicitly assumes a fixed price level
– long-run horizon implicitly assumes flexible price level

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 Shortcomings of PPP
• There is little empirical support for absolute purchasing
power parity, see Fig. 16-2.
– 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.
Reasons why PPP may not be accurate:
1. Trade barriers and nontradable products
2. Imperfect competition
3. Differences in measures of average prices for baskets of
goods and services

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 Fig. 16-2: The Yen/Dollar Exchange Rate and
Relative Japan-U.S. Price Levels, 1980–2012

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 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.

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 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.
• 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.
– Because measures of groups of goods and services are
different, the measure of their average prices need not be the
same.

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 Why Price Levels Are Lower in
Poorer Countries?
• Price levels in poorer countries are systematically lower
than in richer countriers, see Fig. 16-3
– The main reason are price differences in non-tradable goods
among countries
– Prices of tradable goods do not differ so much among countries
• 2 theories are able to explain this stylized fact:
1. Balassa-Samuelson effect
– Rich and poor countries differ in the productivity in tradable goods
while they do not differ so much in productivity in non-tradable
goods.

2. Bhagwati-Kravis-Lipsey effect
– Rich and poor countries differ in the capital-labor ratio.

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 Fig. 16-3: Price Levels and Real
Incomes, 2010
Each dot
corresponds to
one country.
It is clear from
the figure that
countries with
higher GDP per
capita have also
relatively higher
price levels.
Why?

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 Balassa-Samuelson effect, see
Fig. 16-3.
• Let’s assume that
– rich countries have relatively higher productivity in tradable
goods
– productivity in non-tradable goods does not differ so much
among rich and poor countries
• If the prices of tradable goods are roughly similar
among countries then
– higher productivity in the tradable sector in rich countries
results in relatively higher wages in this sector
– It consequently also leads to higher wages in the non-tradable
sector. Higher wages in this sector means higher costs in the
production of non-tradable goods. As a result, prices of non-
tradable goods are relatively higher in the richer countries.

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 Bhagwati-Kravis-Lipsey effect,
see Fig. 16-3.
• Poor countries have lower capital-labor ratios than rich
countries.
– Marginal product of labor in poor countries is therefore lower
and wages are thus lower too.
• The production of non-tradable goods (e.g. services) is
labor-intensive
• Labor in poor countries is cheaper and because it is
intensively used in the production of non-tradable
goods, non-tradable goods should be cheaper in poor
countries.
• As a result, the price levels should be lower in poor
countries.
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 The Real Exchange Rate
• Because of the shortcomings of PPP, economists have
tried to generalize the monetary approach to PPP to
make a better theory.
• The real exchange rate is the rate of exchange for
goods and services across countries.
qUS/EU = (E$/€ x PEU)/PUS
– For example, it is the dollar price of a European group of goods
and services relative to the dollar price of an American group
of goods and services:
– If the EU basket costs €100, the U.S. basket costs $120, and
the nominal exchange rate is $1.20 per euro, then the real
exchange rate is 1 U.S. basket per 1 EU basket.

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 Real Appreciation and Depreciation

qUS/EU = (E$/€ x PEU)/PUS

• A real depreciation (a rise in qUS/EU) 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.

• A real appreciation (a fall in qUS/EU) of the value of U.S. products

means a rise 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 more expensive and more
valuable relative to EU goods.

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 The Real Exchange Rate Approach to
Exchange Rates

• According to PPP, exchange rates are determined by

relative average prices:
E$/€ = PUS/PEU

• According to the more general real exchange rate

approach, exchange rates may also be influenced by
the real exchange rate:
E$/€ = qUS/EU x PUS/PEU

• What influences the real exchange rate?

– A change in relative demand of U.S. products
– A change in relative supply of U.S. products

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 Fig. 16-4: Determination of the
Long-Run Real Exchange Rate
Relative supply is
vertical, i.e. it does
not depend on the real
exchange rate, as the
product in the long-
run is determined by
factor supplies and
productivity.
Relative demand is
upward sloping. A rise
in the real exchange
rate (depreciation)
makes the U.S. export
cheaper and the
demand for U.S.
products thus rises.
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 The Real Exchange Rate Approach to
Exchange Rates
• An increase in relative demand for U.S. products
increases the price of U.S. goods relative to the price of
foreign goods.
– A real appreciation of the value of U.S. goods: PUS rises relative to E$/€
x PEU. The real appreciation of the value of U.S. goods makes U.S.
exports more expensive and imports into the U.S. less expensive

• An increase in relative supply of U.S. products decreases

the price of U.S. goods relative to the price of foreign goods.
– A real depreciation of the value of U.S. goods: PUS falls relative to E$/€
x PEU. The real depreciation of the value of U.S. goods makes U.S.
exports less expensive and imports into the U.S. more expensive

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 The Real Exchange Rate Approach to
Exchange Rates
• A more general approach to explain exchange rates. Both
monetary factors and real factors influence nominal exchange
rates:
1a. Increases in monetary levels lead to temporary inflation, real
exchange rate does not change and nominal exchange rate depreciates
according to the relative PPP.
1b. Increases in monetary growth rates lead to persistent inflation,
real exchange rate does not change and nominal exchange rate
depreciates according to the relative PPP.
2a. Increases in relative demand of domestic products lead to a real
appreciation. As the price levels do not change (no changes on money
markets), it leads to nominal appreciation.
2b. Increases in relative supply of domestic products lead to a real
depreciation, the impact on nominal exchange rate is not clear. Why?

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 The Real Exchange Rate Approach to
Exchange Rates
• An increase in the relative supply of domestic products
leads to
1. depreciation of the real exchange rate
2. increase of domestic output
• An increase in domestic output rises the transaction
demand for real money balances in domestic economy:
PUS = MsUS/L (R$, YUS)
– Thus the level of average domestic prices is predicted to
decrease relative to the level of average foreign prices.
– The effect on the nominal exchange rate is ambiguous:
E$/€ = qUS/EU x PUS/PEU
?

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 Table 16-1: Effects of Money Market and
Output Market Changes on the Long-Run
Nominal Dollar/Euro Exchange Rate, E$/€

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 The Real Exchange Rate Approach to
Exchange Rates
• When economic changes are influenced only by monetary
factors, and when the assumptions of PPP hold, nominal
exchange rates are determined by PPP.
– The real exchange rate does not change .

• 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.
– An increase in relative demand for domestic products leads to real
as well as nominal appreciation.
– An increase in relative supply of domestic products leads to real
depreciation, the impact on nominal exchange rate is ambiguous.

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 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.

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 Summary

3. Empirical support for PPP is weak.

– Trade barriers, nontradable products, imperfect competition
and differences in price measures may cause the empirical
shortcomings of PPP.
4. 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.

5. The Fisher effect shows that differences in nominal

interest rates are equal to differences in inflation rates.

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 Summary

6. 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.

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