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Chapter 16 (5)
Price Levels and the Exchange Rate
in the Long Run
◼ Chapter 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
Summary
APPENDIX TO CHAPTER 16 (5): The Fisher Effect, the Interest Rate, and the Exchange Rate under the
Flexible-Price Monetary Approach
92 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
◼ Chapter 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 because, 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
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:
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
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. Because 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
Chapter 16 (5) Price Levels and the Exchange Rate in the Long Run 93
this 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
◼ Answers to Textbook Problems
1. According to the purchasing power parity
2. A real currency appreciation may result from an increase in the demand for nontraded goods
relative to tradables, which would cause an appreciation of the exchange rate because the increase in
the demand for nontradables raises their price, raising the domestic price level and causing the
currency to appreciate. In this case, exporters are indeed hurt. Real currency appreciation may occur
for different reasons, however, with different implications for exporters’ incomes. A shift in foreign
3. a. A tilt of spending toward nontraded products causes the real exchange rate to appreciate as the
price of nontraded goods relative to traded goods rises (the real exchange rate can be expressed
as the price of tradables to the price of nontradables).
b. A shift in foreign demand toward domestic exports causes an excess demand for the domestic
4. The trade barriers, at times, act as a high potential barrier for a product to be traded between two
countries. Trade barriers increase selling price of a commodity in one country than the other. Hence,
the law of one price does not hold good in this case. Similarly, an imperfectly competitive market
structure also allows the same product to be sold at higher prices in one country compared to another.
If the demand structure in one market is relatively inelastic, the seller charges more compared to
5. The real effective exchange rate series for Britain shows an appreciation of the pound from 1977 to
1981, followed by a period of depreciation. Note that the appreciation is sharpest after the increase
in oil prices starts in early 1979; the subsequent depreciation is steepest after oil prices soften in 1982.
An increase in oil prices increases the incomes received by British oil exporters, raising their demand
94 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
for goods. The supply response of labor moving into the oil sector is comparable to an increase in
6. The rationale of PPP says that a consumer is able to buy the same amount of commodities with
his/her given money income, both from the domestic country and from a foreign country. When
inflation level increases, the value of money falls— this reduces the purchasing power. If inflation in
7. The mechanism would work through expenditure effects with a permanent transfer from Poland
to the Czech Republic appreciating the koruna (Czech currency) in real terms against the zloty
8. The relative PPP makes sense when we evaluate the purchasing power parity based on the
government data.
The absolute measure of PPP predicts the exchange rate between the two currencies. On the other
hand, the relative PPP compares the percentage an exchange rate changes in relation to inflation
differences. The relative PPP makes sense when the countries base their price level estimates on
9. Because the tariff shifts demand away from foreign exports and toward domestic goods, there is a
10. The price in the US = US$ 100 and the exchange rate is 2.4
Hence the price of the same product in Brazilian currency is 2.4*100 = 240 Real
Transport cost is US$5. Hence, the cost of the product in Brazil 240 + 5×2.4 = 252 real, this is higher
11. A permanent increase in the expected rate of real depreciation of the dollar against the euro leads to a
permanent increase in the expected rate of depreciation of the nominal dollar/euro exchange rate,
12. Suppose there is a temporary fall in the real exchange rate in an economy, that is, the exchange
rate appreciates today and then will depreciate back to its original level in the future. The expected
Chapter 16 (5) Price Levels and the Exchange Rate in the Long Run 95
the real exchange rate. This event may also cause the nominal exchange rate to appreciate if the effect
of a current appreciation of the real exchange rate dominates the effect of the expected depreciation
of the real exchange rate.
13. The peso/pound interest difference is the sum of expected rate of real peso depreciation and the
expected inflation difference between the Argentina and UK.
14. The initial effect of a reduction in the money supply in a model with sticky prices is an increase
in the nominal interest rate and an appreciation of the nominal exchange rate. The real interest rate,
which equals the nominal interest rate minus expected inflation, rises by more than the nominal
interest rate because the reduction in the money supply causes the nominal interest rate to rise and
deflation occurs during the transition to the new equilibrium. The real exchange rate depreciates
during the transition to the new equilibrium (where its value is the same as in the original state).
This satisfies the real interest parity relationship, which states that the difference between the
domestic and the foreign real interest rate equals the expected depreciation of the domestic real
15. One answer to this question involves the comparison of a sticky-price with a flexible-price model. In
a model with sticky prices, a reduction in the money supply causes the nominal interest rate to rise
and, by the interest parity relationship, the nominal exchange rate to appreciate. The real interest rate,
which equals the nominal interest rate minus expected inflation, increases both because of the
An alternative approach is to consider a model with perfectly flexible prices. As discussed in the
preceding paragraph, an increase in expected inflation causes the nominal interest rate to increase and
the currency to depreciate, leaving the expected real interest rate unchanged. If there is an increase in
the expected real interest rate, however, this implies an expected depreciation of the real exchange
16. If long-term rates are higher than short-term rates, it suggests that investors expect interest rates to be
higher in the future; that is why they demand a higher rate of return on a longer bond. If they expect
17. If we assume that the real exchange rate is constant, then the expected percentage change in the
exchange rate is simply the inflation differential. As the question notes, this relationship holds better
over the long run. Starting from interest parity, we see that R = R* + %eE. The change in the
96 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
On the other hand, if the real exchange rate changes or is expected to change, we would say that
%eE = %eq +
–
*. In that case, there can be a significant wedge between r and r*. Thus, if
18. If markets are fairly segmented, then temporary moves in exchange rates may lead to wide deviations
from PPP even for tradable goods. In the short run, firms may not be able to respond by opening up
19. Recall the definition of the real exchange rate as q$/€ = (E$/€ × PEU)/PUS. According to the problem,
U.S. export goods have a greater weight in the U.S. CPI (price level) than in the foreign CPI.
Furthermore, U.S. import goods have a smaller weight in the U.S. CPI. Thus, an increase in the U.S.
20. As indicated by the graph below, there is a strong and positive relationship between GNI per capita in
a country and the dollar price of a Big Mac:
Pakistan
India
Philippines
Indonesia
Sri Lanka
Egypt
Ukraine
China
Thailand
Peru
Colombia
South Africa
Brazil
Costa Rica
Venezuela
Uruguay
Malaysia
Mexico
Turkey
Latvia
Chile
Poland
Hungary
Lithuania
Estonia
Russia
Czech Republic
Portugal
Greece
Israel
Korea
New Zealand
Saudi Arabia
Spain
Italy
Ireland
Japan
United Kingdom
France
Finland
Belgium
Germany
Australia
Canada
Denmark
United Arab Emirates
Austria
Sweden
Netherlands
United States
Hong Kong
Switzerland
Singapore
Norway
2468
BigMac
0 20000 40000 60000
GNIpc
