Chapter 15PreviewThe Behavior of Exchange RatesThe Behavior of Exchange Rates (cont.)Law of One PriceLaw of One Price (cont.)Slide 7Purchasing Power ParityPurchasing Power Parity (cont.)Slide 10Monetary Approach to Exchange RatesMonetary Approach to Exchange Rates (cont.)Slide 13Slide 14Slide 15The Fisher EffectSlide 17Slide 18Slide 19Slide 20Slide 21Slide 22The Role of Inflation and ExpectationsThe Role of Inflation and Expectations (cont.)Slide 25Shortcomings of PPPShortcomings of PPP (cont.)Slide 28Slide 29Slide 30The Real Exchange Rate Approach to Exchange RatesThe Real Exchange Rate Approach to Exchange Rates (cont.)Slide 33Slide 34Slide 35Slide 36Determining the Long Run Real Exchange RateDetermining the Long Run Real Exchange Rate (cont.)Determining the Long Run Real Exchange Rate (cont.)Slide 40Slide 41Slide 42Slide 43Interest Rate DifferencesReal Interest RatesReal Interest Rates (cont.)SummarySummary (cont.)Slide 49Slide 50Law of One Price for Hamburgers?Price Levels and IncomesPowerPoint PresentationSlide 54Slides prepared by Thomas BishopChapter 15Price Levels and the Exchange Rate in the Long RunCopyright © 2006 Pearson Addison-Wesley. All rights reserved.15-2Preview•Law of one price•Purchasing power parity•Long run model of exchange rates: monetary approach •Relationship between interest rates and inflation: Fisher effect•Shortcomings of purchasing power parity•Long run model of exchange rates: real exchange rate approach•Real interest ratesCopyright © 2006 Pearson Addison-Wesley. All rights reserved.15-3The Behavior of Exchange Rates•What models can predict how exchange rates behave?In last chapter we developed a short run model and a 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 that prices of goods and services and factors of production that build those goods and services adjust to supply and demand conditions so that their markets and the money market are in equilibrium.Because prices are allowed to change, they will influence interest rates and exchange rates in the long run models.Copyright © 2006 Pearson Addison-Wesley. All rights reserved.15-4The Behavior of Exchange Rates (cont.)•The long run models are not intended to be completely realistic descriptions about how exchange rates behave, but ways of generalizing how market participants form expectations about future exchange rates.Copyright © 2006 Pearson Addison-Wesley. All rights reserved.15-5Law of One Price•The law of one price simply 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.Why? Suppose the price of pizza at one restaurant is $20, while the price of the same pizza at a similar restaurant across the street is $40.What do you predict to happen? Many people would buy the $20 pizza, few would buy the $40.Copyright © 2006 Pearson Addison-Wesley. All rights reserved.15-6Law of One Price (cont.)Due to the increased demand, the price of the $20 pizza would tend to increase.Due to the decreased demand, the price of the $40 pizza would tend to decrease.People would have an incentive to adjust their behavior and prices would tend to adjust to reflect this changed behavior until one price is achieved across markets (restaurants).Copyright © 2006 Pearson Addison-Wesley. All rights reserved.15-7Law of One Price (cont.)•Consider a pizza restaurant in Seattle one across the border in Vancouver. •The law of one price says that the price of the same pizza (using a common currency to measure the price) in the two cities must be the same if barriers between competitive markets and transportation costs are not important:PpizzaUS = (EUS$/Canada$) x (PpizzaCanada)PpizzaUS = price of pizza in SeattlePpizzaCanada = price of pizza in VancouverEUS$/Canada$ = US dollar/Canadian dollar exchange rateCopyright © 2006 Pearson Addison-Wesley. All rights reserved.15-8Purchasing Power Parity•Purchasing power parity is the application of the law of one price across countries for all goods and services, or for representative groups (“baskets”) of goods and services. PUS = (EUS$/Canada$) x (PCanada)PUS = price level of goods and services in the USPCanada = price level of goods and services in CanadaEUS$/Canada$ = US dollar/Canadian dollar exchange rateCopyright © 2006 Pearson Addison-Wesley. All rights reserved.15-9Purchasing Power Parity (cont.)•Purchasing power parity implies that EUS$/Canada$ = PUS/PCanadaThe price levels adjust to determine the exchange rate.If the price level in the US is US$200 per basket, while the price level in Canada is C$400 per basket, PPP implies that the US$/C$ exchange rate should be US$200/C$400 = US$ 1/C$ 2 Purchasing power parity says that each country’s currency has the same purchasing power: 2 Canadian dollars buy the same amount of goods and services as does 1 US dollar, since prices in Canada are twice as high.Copyright © 2006 Pearson Addison-Wesley. All rights reserved.15-10Purchasing Power Parity (cont.)•Purchasing power parity comes in 2 forms:•Absolute PPP: purchasing power parity that has already been discussed. Exchange rates equal price levels 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 tCopyright © 2006 Pearson Addison-Wesley. All rights reserved.15-11Monetary Approach to Exchange Rates•Monetary approach to the exchange rate: uses monetary factors to predict how exchange rates adjust in the long run.It uses the absolute version of PPP.It assumes that prices adjust in the long run.In particular, price levels adjust to equate real (aggregate) money supply with real (aggregate) money demand. This implies: PUS = MsUS/L (R$, YUS) PEU = MsEU/L (R€, YEU)Copyright © 2006 Pearson Addison-Wesley. All rights reserved.15-12Monetary Approach to Exchange Rates (cont.)•To the degree that PPP holds and to the degree that prices adjust to equate real money supply with real money demand, we have the following prediction: •The exchange rate is determined in the long run by prices, which are determined by the relative supply of money across countries and the relative