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EXCHANGE RATES I: THE MONETARY APPROACH IN THE LONG RUN
1 Exchange Rates and Prices in the Long Run 2 Money, Prices, and Exchange Rates in the Long Run 3 The Monetary A Approach h 4 Money, Interest, and Prices in the Long Run 5 Monetary Regimes and Exchange Rate Regimes 6 Conclusions

Chapter Outline
1. Exchange Rates and Prices in the Long Run 2. Money, Prices and Exchange Rates in the Long Run 3. The Monetary Approach 4. Money, Interest, and Prices in the Long Run 5. Monetary Regimes and Exchange Rate Regimes 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 g zone, how should this affect the $/ exchange rate in the long run?

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1. Exchange Rates and Prices in the Long Run

The notion of arbitrage

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).

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The Law of One Price

Key assumption: frictionless trade
No transaction costs No 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 currency. Otherwise, there would be a profit opportunity from buying low and selling high (arbitrage).

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The Law of One Price

Is the LOOP true in the data? 2009, in US $
Abidjan Domesticcleaning (1hr) Oranges(1kg) 4.34 1.3 Amsterdam Beijing 15.71 2.57 4.39 2.87 HongKong Geneva Tehran 12.9 2.26 25.23 2.99 3.52 1.81

Source: Economist Intelligence Unit.

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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 key difference: goods rather than currencies.
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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

As an index, whose variations are given by

Multilateral effective exchange rate

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Real Exchange Rate in the Data

How does the real exchange rate behave in the 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).

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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

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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 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.

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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)

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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

q
Big Mac

Big Mac index =

1 =

Big Mac E $/local currency Plocal Big Mac PUS

The % deviation (+/) from the US price measures the over/under valuation of the local currency based on the burger basket. Updated every year: p g http://www.economist.com/markets/Bigmac/ In 2004 they tried the same exercise with another global homogeneous product: the Starbucks tall latte.

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Big Max Index (Feb. 4, 09)

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The Big Mac Index

Deviations from PPP and economic development

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

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Application 1: Inflation and Nominal Exchange Rates Consider 2 countries, A and B g in country y B than in country y A, , Inflation higher 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

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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 currency c rrenc was as undervalued nder al ed b by 38% Caveats

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Application 3: Comparing GDP Across Countries In 2008, US GDP = bn$ 14,441 US GDP per capita= $47,440 $47 440 Chinese GDP = bn$ 4,327 (30% of US level) Chinese GDP per capita= $3,259 (6.9% of US level) ( t market (at k t exchange h rate) t )

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Application 3: Comparing GDP Across Countries But real exchange rate qC/US =0.546 =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

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Application 3: Comparing GDP Across Countries Ratio of Chinese GDP to US GDP

0.6

0.5

0.4

0.3

market exchange rate PPP-adjusted

02 0.2

0.1

0 2000 2001 2002 2003 2004 2005 2006 2007 2008

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Application 3: Comparing GDP Across Countries US GDP per capita as a multiple of Burundis & Bangladeshs
350 300

250

200 market rate 150 PPP adjusted

100

50

0 Burundi Bangladesh

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