Exchange Rate – Prices

Law of One Price

 Given free trade (that is, without tariffs, quotas or any other
barriers) and in absence of any other externalities like
transportation cost, market imperfection etc., the price of the
same good will be the same in all the countries.

 Example

Suppose a car costs $18000 in US. Then the same model and
make will be priced at €15000 in Germany given the exchange
rate prevailing is $1.2 = €1

 Problem

What will happen if the car is sold at $20000 in the US?

Sunandan Ghosh, CDS, 2013 2

Implication of LOP
 Given open and costless trade, identical goods must trade at the
same relative price regardless of where they are sold.

 Let the price be PUS in the US and PG be the price in Germany

then
PUS
$/
PG

Sunandan Ghosh, CDS, 2013 3

Purchasing Power Parity (PPP)
 Exchange rate between two countries equals the ratio of price
levels .
PUS
$/
PG

 Increase in domestic price level fall in currency’s domestic

purchasing power proportional depreciation in the forex
market.

 PPP postulates that the price levels are equal when measured in
the same currency.

PUS $/ * PG

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LOP – PPP
 LOP applies for commodity, PPP applies to overall price level.

 Hence, if LOP holds for all commodities, PPP holds.

 Is the reverse true?

 Can PPP hold if LOP does not hols for all goods?

 What about non-traded goods?

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PPP – Absolute and Relative
 Absolute PPP is given by
PUS
$/
PG
 Relative PPP postulates that relative change in the exchange rate
between two countries equals the relative changes in the
national price levels
$ / ,t $ / ,t 1
US ,t G ,t
$ / ,t 1
where,
PUS ,t PUS ,t 1 PG ,t PG ,t 1
US ,t , G ,t
PUS ,t 1 PG ,t 1

and, US ,t G ,t gives the inflation differential.

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Monetary Approach
 Now, given PPP, let’s check how exchange rates and monetary
factors interact in the long run – long run because prices are
flexible.
PUS
 Assume that in the long-run PPP holds $/
PG
 That is, we assume that in the long-run there exists no market
imperfection or externalities that prevent prices and exchange
rates to adjust and full-employment equilibrium is achieved.

 Conditions from money markets are given by –

S
M US M GS
PUS & PG
L( RUS , YUS ) L ( RG , YG )

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Monetary Approach (Continued)
 Given PPP the exchange rate between the US and Germany
depends on their price levels.

 These price levels in the long-run depends on their respective

money markets.

 Hence, the exchange rate in the long-run depends on the relative

money supplies and relative money demands for the two
currencies.

 What if there is an increase in

1. Permanent rise in US money supply?

2. A rise in interest rate in US?
3. A rise in US output?

Sunandan Ghosh, CDS, 2013 8

Persistent Inflation
 Suppose there is a permanent increase in money supply – we
have seen that effects differ in the short-run versus the long-run
– that is real money supply in the long-run decreases as prices
increase so that
M 1S M 2S
P1 P2

 Suppose there is a constant growth of money supply the price

levels will rise continually persistent inflation
e Pe P
 Let gives the perceived rate of inflation
P
E$e/ E$/
 Interest Parity Condition: R R$
E$ /

Sunandan Ghosh, CDS, 2013 9

Persistent Inflation
 If relative PPP holds then
$ / ,t $ / ,t 1
US ,t G ,t
$ / ,t 1

 Hence, if expectations are taken in to consideration then,

e
$/ ,t $ / ,t 1 e e
US G
$ / ,t 1
 Combining we have
e e
US G R$ R
 As expected depreciation is given by difference in expected
national inflation rates, given relative PPP, interest rate
difference is given by difference in expected national inflation
rates.
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Fisher Effect
 This long-run relationship between inflation and interest rate is
called the Fisher Effect and is given by
e e
US G R$ R
 LHS is the expected inflation differential and RHS is interest rate
differential between the two countries concerned.

 So real rate of return to assets (in either $ or €) remains the

same and the effect of actual inflation coming from expected
inflation is nullified.

 Relate it to the Classical Dichotomy – changes in the monetary

instruments do not affect the real relative prices in the long-run.

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Apparent Paradox
 Given Fisher Effect, we have if inflation rises in one country
e e
relative to the other, that is, US G 0 , then relative interest
rate will also rise, that is, R$ R 0

 Again, as inflation rises, there is expected depreciation given

relative PPP:
e
$/ ,t $ / ,t 1 e e
US G
$ / ,t 1

 However, fall in interest rate is linked to depreciation (think of

the effect of a permanent increase in money supply).

 Solution to paradox – real money supply is unchanged in the

long-run as prices are also flexible.

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Looking Back (slide 12, session 20)

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Empirical Evidences
 Absolute PPP or LOP does not hold.

 Neither relative PPP has strong empirical evidences.

 Why studying them? Are they useless?

 Think of trade barriers, non-tradables, taste

differentials, imperfect competition, market
imperfections.

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Home Work
 Till now we have talked about nominal exchange rate

 Think of real exchange rate

 Think of real interest parity

q e$ / ,t
q$ / ,t 1 e e
RUS RG
q$ / ,t 1

 Read: Krugman (Chapter 15), Gandolfo (Chapter 9)

and Pugel (Chapter 19)
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