978-0132146654 Chapter 16 Lecture Notes

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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

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.

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.