exchange rate movements in the long term

International Finance 130440-1165

Exchange rate movements in the long term



Lecture outline

The law of one price The purchasing power parity (PPP) theory The monetary model and PPP Extensions of the PPP theory


The law of one price

Assumption: no barriers to trade, no transportation costs The price of identical goods should be equal in different

countries if expressed in the same currency

Example: If ER=1,5 USD/GBP PGBP=30 GBP PUSD=45 USD


The law of one price

PGBP>PUSD imports from USA price

falls in GB

PUSD= ER USD/GBP*PGB


The purchasing power parity theory

The purchasing power (PP) of a currency is reflected in the nominal price of a reference basket of goods and services.

If one can buy the same basket for 30 GBP and for 45 USD the PP of the GBP is higher than of the USD



The nominal ER of two currencies conforms the PPP if for a unit of a currency we can purchase the same basket of goods in our country and abroad



The PP of two currencies is measured with the real ER

RER= NER* Pn/Pa

NER*Pn/Pa=1 RER=1



Overvalued currency if RER>1 it means:

NER* Pn>Pa

Undervalued currency if RER<1 it means:

NER* Pn>Pa

Arbitrage Pn and NER decreases (or

increases) so RER=1


The absolute and relative version of PPP theory

The absolute version seem not to be confirmed empirically

RER does not equal 1!


The PLN RER vs EUR

Źródło: R. Kelm, Model behawioralnego kursu równowagi złotego do euro, Bank i Kredyt 41 (2), NBP,

Warszawa 2010.


The absolute and relative version of PPP theory

The relative version of the theory: the NER changes of one currency equal the

difference between the domestic price changes and abroad

(NERt-NERt-1)/NERt-1=Πnt-Πat


Inflation differentials

According to the PPP theory the changes in the nominal ER are due to inflation differentials

Πn=3% Πa=1% the national currency

should depreciate at 2% p.a.

NERt/NERt-1=101/103=98%


Empirical verification of PPP

Empirical proofs only in a longer term The PPP RER is offen used to compare

wealth in different countries Problem- consumption structure Depending on the reference basket- there

are several RER PPP


The monetary model based on PPP

Assumption: NER= Pn/Pa so the PPP is fullfilled

Pn=Mn/L(in, Yn)

Pa= Ma/L(ia, Ya)

NER is determined in the long term by the relative money supply and demand in two countries



Money supply increase price increase currency depreciation

Interest rate increase decrease of money demand by constant money supply increase of prices depreciation

Production increase money demand increase price decrease appreciation



Puzzling evidence?? The influence of interest rate changes on

ER depends on the reason why the interest rate changed!



Raising money supply Persistent inflation The interest rate parity and PPP If people expect the PPP theory to hold, the

interest rate difference between two countries equals the difference between the expected inflation in those two countries



Πe=(Pe-P)/P

(NERe-NER)/ NER= Πen- Πea

in= ia+ (NERe-NER)/NER

in- ia = Πen- Πea


The Fisher effect

in- ia = Πen- Πea

The increase of the expected inflation in one country causes in a long term an identical increase of the interest rate denominated in the currency of this country


The Fisher effect

The effect holds only in long term It explains the paradox of the relation

between ir changes and er changes In the short term- sticky prices


The empirical verification of the relative PPP theory

Źródło: R. Kelm, Model behawioralnego kursu równowagi złotego do euro, Bank i Kredyt 41 (2), NBP,

Warszawa 2010.


Main factors impeding PPP

Barriers to trade Non-tradable goods Incompetitive market structures Differences in consumption structures

and prices The Ballassa-Samuelson effect


Barriers to trade

Transportation cost Trade policy Barriers to capital movement


Nontradable goods

Services No international price relation Great share of nontradables in GDP


The Big Mac Index


Incompetitive market structures

Market segmentation Price discrimination Dumping prices


Consumption structure differences

Different measures of prices and inflation Majority of consumption- national

products Differences in consumption structure

influence PPP ER


The Balassa-Samuelson effect

The price level in countries with higher labour productivity grwoth is higher than in countries with lower productivity growth

Differences in productivity growth in tradables and nontradables sectors

Productivity growth wages growth in both sectors


The Balassa-Samuelson effect

Higher inflation in the nontradables sector Effect- countries with higher

productivity higher price level RER >1

Especially- cathing up countries


Extending the PPP theory

Real ER movements Long term equilibrium on the FX market International long term ineterest rate

differentials


Real exchange rate movements

RER depreciation RER appreciation

Example: NER USD decreases from 0,7 to 0,6 EUR/USD

ΠEUR= 105 and ΠUSD=130

This means USD RER appreciation

RERt/RERt-1= (NERt/NERt-1)* Πn/Πa

=(0,6/0,7)*(130/105)= 1,06


Long term equilibrium on the FX market

NER=RER*(Pn/Pa)

by given RER the NER is influenced by money demand and supply

by given money demand and supply NER is influenced by RER



Shifts in relative money supply Shifts in relative money supply growth

rates Shifts in relative demand for products Shifts in relative supply of products



If all shock are monetary in a long term the RER conforms PPP!!!

Monetary shocks influence only the PP which changes the ER

If real shocks occure- the ER does not conform to PPP


International long term interest rate differentials

Interest rate differentials depend not only on inflation expectations but also on expected RER

in-ia= (NERe-NER)/NER +(Πen - Πea )

The interest rate differential equals the expected real depreciation of the ER and expected inflation differentials


Real ineterest rate parity

The expected RER changes equal the expected real interest rate changes

rine-riae=(RERe-RER)/RER


Summing up

No empirical evidence of the absolute version of the PPP theory

NER*Pn/Pa=1 RER=1

The relative version of the PPP theory

(NERt-NERt-1)/NERt-1=Πnt-Πat

Empirical evidence only in the long term


Summing up

The monetary model based on PPP The Fisher effect

in- ia = Πen- Πea

Factors impeding the PPP theory Extensions of the PPP theory


References P. Krugman, M.Obstfeld, International economics: theory and policy. Part II,

Pearson, Addison Wesley, Boston 2009 R. Kelm, Model behawioralnego kursu równowagi złotego do euro, Bank i

Kredyt 41 (2), NBP, Warszawa 2010 M. Rubaszek, Economic convergence and the fundamental equilibrium

exchange rate in Poland, Bank i Kredyt 40 (1), NBP, Warszawa 2009. R. Clarida, J. Gali, Sources of real exchange rate fluctuations: how

importanta are nominal shocks?, NBER Working Paper, 1994. M. Wagner, J. Hlouskova, What’s really the story with this Balassa-Samuelson Effect in the CEECs?, Diskussionschriften, Universität

Bern, 2004

exchange rate movements in the long term

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