Chapter 15
Price Levels and the Exchange Rate
in the Long Run
1 Chapter Organization
The Law of One Price
Purchasing Power Parity
The Relationship Between PPP and the Law of One Price
Absolute PPP and Relative PPP
汉英字典免费下载A Long-Run Exchange-Rate Model Bad on PPP
The Fundamental Equation of the Monetary Approach
Ongoing Inflation, Interest Parity, and PPP
The Fisher Effect
Empirical Evidence on PPP and the Law of One Price
Box: Some Meaty Evidence on the Law of One Price
Explaining the Problems with PPP
Trade Barriers and Nontradables
Departures from Free Competition
Differences in Consumption Patterns and Price Level Measurement
PPP in the Short Run and in the Long Run
Box: Sticky Prices and the Law of One Price: Evidence From Scandinavian Duty-free Shops
Ca Study: Why Price Levels are Lower in Poorer Countries
出国留学咨询Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates
The Real Exchange Rate
Demand, Supply, and the Long-Run Real Exchange Rate
Nominal and Real Exchange Rates in Long-Run Equilibrium
International Interest Rate Differences and the Real Exchange Rate
Real Interest Parity
Summary
Appendix: The Fisher Effect, the Interest Rate, and the Exchange Rate under the Flexible-Price
Monetary Approach
2
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Chapter Overview
The time frame of the analysis of exchange rate determination shifts to the long run in this chapter. An analysis of the determination of the long-run exchange rate is required for the completion of the short-run exchange rate model since, as demonstrated in the previous two chapters, the long-run expected exchange rate affects the current spot rate. Issues addresd here include both monetary and real-side determinants of the long-run real exchange rate. The development of the model of the long-run exchange rate touches on a number of issues, including the effect of ongoing inflation on the exchange rate, the Fisher effect, and the role of tradables and nontradables. Empirical issues, such as the breakdown of purchasing power parity in the 1970s and the correlation between price levels and per capita income, are addresd within this framework.
The law of one price, which holds that the prices of goods are the same in all countries in the abnce of transport costs or trade restrictions, prents an intuitively appealing introduction to long-run exchange rate determination. An extension of this law to ts of g
oods motivates the proposition of absolute purchasing power parity. Relative purchasing power parity, a less restrictive proposition, relates changes in exchange rates to changes in relative price levels and may be valid even when absolute PPP is not. Purchasing power parity provides a cornerstone of the monetary approach to the exchange rate, which rves as the first model of the long-run exchange rate developed in this chapter. This first model also demonstrates how ongoing inflation affects the long-run exchange rate.
The monetary approach to the exchange rate us PPP to model the exchange rate as the price level in
the home country relative to the price level in the foreign country. The money market equilibrium relationship is ud to substitute money supply divided by money demand for the price level. The
Fisher relationship allows us to substitute expected inflation for the nominal interest rate. The resulting relationship models the long-run exchange rate as a function of relative money supplies, the inflation differential and relative output in the two countries;
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E (M/M*gment) l(prigide – p*e, (Y*/Y))
The l function reprents the ratio of foreign to domestic money demand; thus, both the difference in expected inflation rates and the output ratio enter the function with a positive sign. An increa in inflation at home means higher home interest rates (through the Fisher equation) and lower home money demand. An increa in foreign output rais foreign money demand.
One result from this model that students may find initially confusing concerns the relationship between the long-run exchange rate and the nominal interest rate. The model in this chapter provides an example of an increa in the interest rate associated with exchange rate depreciation. In contrast, the short-run analysis in the previous chapter provides an example of an increa in the domestic interest rate associated with an appreciation of the currency. The different relationships between the exchange
rate and the interest rate reflect different caus for the ri in the interest rate as well as different assumptions concerning price rigidity. In the analysis of the previous chapter, the 学习压力大
interest rate ris due
to a contraction in the level of the nominal money supply. With fixed prices, this contraction of nominal balances is matched by a contraction in real balances. Excess money demand is resolved through a ri in interest rates which is associated with an appreciation of the currency to satisfy interest parity. In this chapter, the discussion of the Fisher effect demonstrates that the interest rate will ri in respon to an anticipated increa in expected inflation due to an anticipated increa in the rate of growth of the money supply. There is incipient excess money supply with this ri in the interest rate. With perfectly flexible prices, the money market clears through an erosion of real balances due to an increa in the price level.
This price level increa implies, through PPP, a depreciation of the exchange rate. Thus, with perfectly flexible prices (and its corollary PPP), an increa in the interest rate due to an increa in expected inflation is associated with a depreciation of the currency.
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Empirical evidence prented in the chapter suggests that both absolute and relative PP
P perform poorly for the period since 1971. Even the law of one price fails to hold across disaggregated commodity groups. The rejection of the theories is related to trade impediments (which help give ri to nontraded goods and rvices), to shifts in relative output prices and to imperfectly competitive markets. Since PPP
rves as a cornerstone for the monetary approach, its rejection suggests that a convincing explanation
of the long-run behavior of exchange rates must go beyond the doctrine of purchasing power parity. The Fisher effect is discusd in more detail and accompanied by a diagrammatic exposition in an appendix to the chapter.
A more general model of the long-run behavior of exchange rates in which real-side effects are assigned a role concludes the chapter. The material in this ction drops the assumption of a constant real exchange rate, an assumption that you may want to demonstrate to students is necessarily associated with the assumption of PPP. Motivating this more general approach is easily done by prenting students with a time ries graph of the recent behavior of the real exchange rate of the dollar which will demonstrat
e large swings in its value. The real exchange rate, q, is the ratio of the foreign price index, expresd in domestic currency, to the domestic price index, or, equivalently, E胸罩英文怎么说 q (P/P沈阳英语翻译*). The chapter includes an informal discussion of the manner in which the long-run real exchange rate, q, is affected by permanent changes in the supply or demand for a country’s products.
