ECON 311 1nd Edition Lecture 10 Outline of Last Lecture I The Term Structure of Interest Rates II Bond Investing Strategy III Yield Curves and Expected Inflation Outline of Current Lecture I Purchasing Power Parity Current Lecture I Purchasing Power Parity a Application of the law of one price to foreign exchange markets i A dollar should have some purchasing power everywhere ii Value of 1 in the US Value of 1 in a foreign country E nominal exchange rate foreign currency US P US price level P Foreign Price Level Value of 1 in US 1 P Value of 1 in a Foreign Country E P so E P P Where P is the foreign inflation rate and P is the US inflation rate Suppose the US inflation rate is 3 and the Mexican inflation rate is 5 The US dollar will depreciate by 2 relative to the peso Difference in inflation rates causes the fluctuation in exchange rates Big Mac Index comparing Big Mac prices globally Price of Big Mac 32 pesos big mac These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute Price of Big Mac 3 big mac So Exchange rate 32 pesos 3 10 67 pesos 1 If this is the actual exchange rate the US dollar is over valued and will depreciate in the long run Purchasing Power Parity Implications In the Long Run 1 Relative Price Levels a If P increases E decreases 2 Trade Barriers a If US trade barriers increase E increases 3 Relative Preferences for Foreign and Domestic Goods 4 Relative Productivity a If US productivity increases E increases This works in the long run but NOT the short run