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82 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition
Chapter 16
Price Levels and the Exchange Rate
in the Long Run
.1 nChapter Organization
The Law of One Price
Purchasing Power Parity
The Relationship Between PPP and the Law of One Price
Absolute PPP and Relative PPP
A Long-Run Exchange Rate Model Based on PPP
The Fundamental Equation of the Monetary Approach
Ongoing Inflation, Interest Parity, and PPP
The Fisher Effect
Empirical Evidence on PPP and the Law of One Price
Explaining the Problems with PPP
Trade Barriers and Nontradables
Departures from Free Competition
Differences in Consumption Patterns and Price Level Measurement
Box: Some Meaty Evidence on the Law of One Price
PPP in the Short Run and in the Long Run
Case Study: Why Price Levels Are Lower in Poorer Countries
Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates
The Real Exchange Rate
Demand, Supply, and the Long-Run Real Exchange Rate
Box: Sticky Prices and the Law of One Price: Evidence From Scandinavian Duty-Free Shops
Nominal and Real Exchange Rates in Long-Run Equilibrium
International Interest Rate Differences and the Real Exchange Rate
Real Interest Parity
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
83 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition
Summary
APPENDIX TO CHAPTER 16: The Fisher Effect, the Interest Rate, and the Exchange Rate Under the
Flexible-Price Monetary Approach
nChapter Overview
The time frame of the analysis of exchange rate determination shifts to the long run in this chapter. An
analysis of the determination of the long-run exchange rate is required for the completion of the
short-run exchange rate model since, as demonstrated in the previous two chapters, the long-run
expected exchange rate affects the current spot rate. Issues addressed here include both monetary and
real-side determinants of the long-run real exchange rate. The development of the model of the long-run
exchange rate touches on a number of issues, including the effect of ongoing inflation on the exchange
rate, the Fisher effect, and the role of tradables and nontradables. Empirical issues, such as the
breakdown of purchasing power parity in the 1970s and the correlation between price levels and per
capita income, are addressed within this framework.
The law of one price, which holds that the prices of goods are the same in all countries in the absence of
transport costs or trade restrictions, presents an intuitively appealing introduction to long-run exchange
rate determination. An extension of this law to sets of goods motivates the proposition of absolute
purchasing power parity. Relative purchasing power parity, a less restrictive proposition, relates
changes in exchange rates to changes in relative price levels and may be valid even when absolute PPP
is not. Purchasing power parity provides a cornerstone of the monetary approach to the exchange rate,
which serves as the first model of the long-run exchange rate developed in this chapter. This first model
also demonstrates how ongoing inflation affects the long-run exchange rate.
The monetary approach to the exchange rate uses PPP to model the exchange rate as the price level in
the home country relative to the price level in the foreign country. The money market equilibrium
relationship is used to substitute money supply divided by money demand for the price level. The
resulting relationship models the long-run exchange rate as a function of relative money supplies, real
interest rates, and relative output in the two countries:
Eh/f Ph/Pf Mh/Mf {L(Rf,Yf)/L(Rh,Yh)}
One result from this model that students may find initially confusing concerns the relationship between
the long-run exchange rate and the nominal interest rate. The model in this chapter provides an example
of an increase in the interest rate associated with exchange rate depreciation. In contrast, the short-run
analysis in the previous chapter provides an example of an increase in the domestic interest rate
associated with an appreciation of the currency. These different relationships between the exchange
rate and the interest rate reflect different causes for the rise in the interest rate as well as different
assumptions concerning price rigidity. In the analysis of the previous chapter, the interest rate rises due
to a contraction in the level of the nominal money supply. With fixed prices, this contraction of nominal
balances is matched by a contraction in real balances. Excess money demand is resolved through a rise
in interest rates which is associated with an appreciation of the currency to satisfy interest parity. In
this chapter, the discussion of the Fisher effect demonstrates that the interest rate will rise in response
to an anticipated increase in expected inflation due to an anticipated increase in the rate of growth of the
money supply. There is incipient excess money supply with this rise in the interest rate. With perfectly
flexible prices, the money market clears through an erosion of real balances due to an increase in the
price level.
This price level increase implies, through PPP, a depreciation of the exchange rate. Thus, with perfectly
flexible prices (and its corollary PPP), an increase in the interest rate due to an increase in expected
inflation is associated with a depreciation of the currency.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
Chapter 16 Price Levels and the Exchange Rate in the Long Run 84
Empirical evidence presented in the chapter suggests that both absolute and relative PPP perform poorly
for the period since 1971. Even the law of one price fails to hold across disaggregated commodity groups.
The rejection of these theories is related to trade impediments (which help give rise to nontraded goods
and services), to shifts in relative output prices, and to imperfectly competitive markets. Since PPP serves
as a cornerstone for the monetary approach, its rejection suggests that a convincing explanation of the
long-run behavior of exchange rates must go beyond the doctrine of purchasing power parity. The Fisher
effect is discussed in more detail and accompanied by a diagrammatic exposition in an appendix to the
chapter.
A more general model of the long-run behavior of exchange rates in which real side effects are assigned
a role concludes the chapter. The material in this section drops the assumption of a constant real
exchange rate, an assumption that you may want to demonstrate to students is necessarily associated
with the assumption of PPP. Motivating this more general approach is easily done by presenting
students with a time-series graph of the recent behavior of the real exchange rate of the dollar which
will demonstrate large swings in its value. The real exchange rate, qh/f , is the ratio of the foreign price
index, expressed in domestic currency, to the domestic price index, or, equivalently, Eh/f qh/f (Ph/Pf).
The chapter includes an informal discussion of the manner in which the long-run real exchange rate, qh/f ,
is affected by permanent changes in the supply or demand for a country’s products.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
