LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Price Levels and the Exchange Rate in the Long Run Bill Gibson
UVM 15 March
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Law of one price LOP simply says that price is same good in different markets
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Law of one price LOP simply says that price is same good in different markets Assumes transportation costs are zero and no barriers to trade.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Law of one price LOP simply says that price is same good in different markets Assumes transportation costs are zero and no barriers to trade. Only true, if at all, in long run
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Law of one price LOP simply says that price is same good in different markets Assumes transportation costs are zero and no barriers to trade. Only true, if at all, in long run In LR sufficient amount of time for prices of all goods and services to adjust to market conditions so that their markets and the money market are in equilibrium
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Law of one price LOP simply says that price is same good in different markets Assumes transportation costs are zero and no barriers to trade. Only true, if at all, in long run In LR sufficient amount of time for prices of all goods and services to adjust to market conditions so that their markets and the money market are in equilibrium LF models are not intended to be completely realistic descriptions
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Law of one price LOP simply says that price is same good in different markets Assumes transportation costs are zero and no barriers to trade. Only true, if at all, in long run In LR sufficient amount of time for prices of all goods and services to adjust to market conditions so that their markets and the money market are in equilibrium LF models are not intended to be completely realistic descriptions Explanation of how agents form expectations about the future exchange rates
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Law of one price LOP simply says that price is same good in different markets Assumes transportation costs are zero and no barriers to trade. Only true, if at all, in long run In LR sufficient amount of time for prices of all goods and services to adjust to market conditions so that their markets and the money market are in equilibrium LF models are not intended to be completely realistic descriptions Explanation of how agents form expectations about the future exchange rates Example What do we call the mechanism that causes LOP to happen?
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Law of one price LOP simply says that price is same good in different markets Assumes transportation costs are zero and no barriers to trade. Only true, if at all, in long run In LR sufficient amount of time for prices of all goods and services to adjust to market conditions so that their markets and the money market are in equilibrium LF models are not intended to be completely realistic descriptions Explanation of how agents form expectations about the future exchange rates Example What do we call the mechanism that causes LOP to happen? Answer: Arbitrage Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
LOP Formal definition P = EP ∗
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
LOP Formal definition P = EP ∗ P domestic price of a good or same bundle of goods
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
LOP Formal definition P = EP ∗ P domestic price of a good or same bundle of goods E nominal exchange rate
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
LOP Formal definition P = EP ∗ P domestic price of a good or same bundle of goods E nominal exchange rate P ∗ foreign price
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
LOP Formal definition P = EP ∗ P domestic price of a good or same bundle of goods E nominal exchange rate P ∗ foreign price Example Let a Big Mac hamburger, sold in 41 countries around the world be sold in China for Rb 12,000 and in the U.S. for 3.00. What then is the implied PPP exchange rate?
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
LOP Formal definition P = EP ∗ P domestic price of a good or same bundle of goods E nominal exchange rate P ∗ foreign price Example Let a Big Mac hamburger, sold in 41 countries around the world be sold in China for Rb 12,000 and in the U.S. for 3.00. What then is the implied PPP exchange rate? Answer: P/P ∗ = 3/12000 = 2.5 × 10−4
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Big Mac
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Big Mac
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Purchasing power parity exchange rate Purchasing power parity exchange rate is the application of LOP for all goods P = EP ∗
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Purchasing power parity exchange rate Purchasing power parity exchange rate is the application of LOP for all goods P = EP ∗ Economist uses MacDonald’s exchange rate
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Purchasing power parity exchange rate Purchasing power parity exchange rate is the application of LOP for all goods P = EP ∗ Economist uses MacDonald’s exchange rate PPP exchange rate looks at goods and not assets
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Purchasing power parity exchange rate Purchasing power parity exchange rate is the application of LOP for all goods P = EP ∗ Economist uses MacDonald’s exchange rate PPP exchange rate looks at goods and not assets Actual exchange rate is an average of goods and assets
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Purchasing power parity exchange rate Purchasing power parity exchange rate is the application of LOP for all goods P = EP ∗ Economist uses MacDonald’s exchange rate PPP exchange rate looks at goods and not assets Actual exchange rate is an average of goods and assets Example Home prices P increase by 10% while foreign prices, P ∗ , increase by 7%. What happens to the exchange rate? Use the hat rule for multiplication
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Purchasing power parity exchange rate Purchasing power parity exchange rate is the application of LOP for all goods P = EP ∗ Economist uses MacDonald’s exchange rate PPP exchange rate looks at goods and not assets Actual exchange rate is an average of goods and assets Example Home prices P increase by 10% while foreign prices, P ∗ , increase by 7%. What happens to the exchange rate? Use the hat rule for multiplication Answer: Pˆ = Eˆ + Pˆ∗ so Eˆ = 3% Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary approach to exchange rate P = M s /L(Y , R )
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary approach to exchange rate P = M s /L(Y , R ) If income rises, prices fall since same money chasing more goods
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary approach to exchange rate P = M s /L(Y , R ) If income rises, prices fall since same money chasing more goods If interest rate rises, prices rise since more money effectively circulating
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary approach to exchange rate P = M s /L(Y , R ) If income rises, prices fall since same money chasing more goods If interest rate rises, prices rise since more money effectively circulating If money supply rises then prices rise
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary approach to exchange rate P = M s /L(Y , R ) If income rises, prices fall since same money chasing more goods If interest rate rises, prices rise since more money effectively circulating If money supply rises then prices rise Example Let money demand be given by Cobb Douglas: M = Y 1+α /R α . Use hats to compute the rate of growth of money demand.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary approach to exchange rate P = M s /L(Y , R ) If income rises, prices fall since same money chasing more goods If interest rate rises, prices rise since more money effectively circulating If money supply rises then prices rise Example Let money demand be given by Cobb Douglas: M = Y 1+α /R α . Use hats to compute the rate of growth of money demand. ˆ = (1 + α)Yˆ − αRˆ Answer: using rule 4: M Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Example
Let α = 4/5 and let money supply growth be equal to 5%. Income growth is 3% and the interest rate increases from 4 to 5%. Compute the change in the prices.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Example
Let α = 4/5 and let money supply growth be equal to 5%. Income growth is 3% and the interest rate increases from 4 to 5%. Compute the change in the prices. Example
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Example
Let α = 4/5 and let money supply growth be equal to 5%. Income growth is 3% and the interest rate increases from 4 to 5%. Compute the change in the prices. Example Answer: 5 − [(1 + 1/5)(3) − (1/5)(25)] = 7.5% = 6.4
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Implies Real exchange rate is one.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Implies Real exchange rate is one. Real interest rates is same both countries
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Implies Real exchange rate is one. Real interest rates is same both countries Exchange rate will adjust to counteract different rates of inflation
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Implies Real exchange rate is one. Real interest rates is same both countries Exchange rate will adjust to counteract different rates of inflation The only people in line at the central bank are importers and exporters
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Implies Real exchange rate is one. Real interest rates is same both countries Exchange rate will adjust to counteract different rates of inflation The only people in line at the central bank are importers and exporters Goods can be more expensive in one country than another but the difference remains constant
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Implies Real exchange rate is one. Real interest rates is same both countries Exchange rate will adjust to counteract different rates of inflation The only people in line at the central bank are importers and exporters Goods can be more expensive in one country than another but the difference remains constant Example If Macedonian has an inflation rate of 8 percent per year, but the European community has only 3 percent, PPP requires that
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Implies Real exchange rate is one. Real interest rates is same both countries Exchange rate will adjust to counteract different rates of inflation The only people in line at the central bank are importers and exporters Goods can be more expensive in one country than another but the difference remains constant Example If Macedonian has an inflation rate of 8 percent per year, but the European community has only 3 percent, PPP requires that Answer: The Macedonian dinar must devalue of 5 percent per year. Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate P = EP ∗
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate P = EP ∗ Use money market to solve for P
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate P = EP ∗ Use money market to solve for P L(R, Y ) = M/P
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate P = EP ∗ Use money market to solve for P L(R, Y ) = M/P M/L(R, Y ) = EM ∗ /L(R ∗ , Y ∗ ) or
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate P = EP ∗ Use money market to solve for P L(R, Y ) = M/P M/L(R, Y ) = EM ∗ /L(R ∗ , Y ∗ ) or E =
M/L(R,Y ) M ∗ /L(R ∗ ,Y ∗ )
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate P = EP ∗ Use money market to solve for P L(R, Y ) = M/P M/L(R, Y ) = EM ∗ /L(R ∗ , Y ∗ ) or E =
M/L(R,Y ) M ∗ /L(R ∗ ,Y ∗ )
Example Money demand is Cobb-Douglas R −α Y 1+α with α = 0.2 and α∗ = 0.4. The money supply is M = 90, M ∗ = 70 and Y = 150, Y ∗ = 100. The interest rate in both countries is 10 percent. Compute the exchange rate:
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate P = EP ∗ Use money market to solve for P L(R, Y ) = M/P M/L(R, Y ) = EM ∗ /L(R ∗ , Y ∗ ) or E =
M/L(R,Y ) M ∗ /L(R ∗ ,Y ∗ )
Example Money demand is Cobb-Douglas R −α Y 1+α with α = 0.2 and α∗ = 0.4. The money supply is M = 90, M ∗ = 70 and Y = 150, Y ∗ = 100. The interest rate in both countries is 10 percent. Compute the exchange rate: Answer:
90/[0.1−0.2 (1501.2 )] 70/[0.1−0.4 (1001.4 )]
= 3.15
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate Raise income Y = 200
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate Raise income Y = 200 This will increase the demand for money and with a fixed supply of money, prices should fall!
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate Raise income Y = 200 This will increase the demand for money and with a fixed supply of money, prices should fall! Then e should fall
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate Raise income Y = 200 This will increase the demand for money and with a fixed supply of money, prices should fall! Then e should fall Example Money demand is Cobb-Douglas R −α Y 1+α with α = 0.2 and α∗ = 0.4. The money supply is M = 90, M ∗ = 70 and Y = 200, Y ∗ = 100. The interest rate in both countries is 10 percent. Compute the exchange rate:
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate Raise income Y = 200 This will increase the demand for money and with a fixed supply of money, prices should fall! Then e should fall Example Money demand is Cobb-Douglas R −α Y 1+α with α = 0.2 and α∗ = 0.4. The money supply is M = 90, M ∗ = 70 and Y = 200, Y ∗ = 100. The interest rate in both countries is 10 percent. Compute the exchange rate: Answer:
90/[0.1−0.2 (2001.2 )] 70/[0.1−0.4 (1001.4 )]
= 2.23
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate Raise R = 12 and thus lower the speculative demand
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate Raise R = 12 and thus lower the speculative demand This should lower demand for money and raise the price level
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate Raise R = 12 and thus lower the speculative demand This should lower demand for money and raise the price level Higher price should depreciate the exchange rate
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate Raise R = 12 and thus lower the speculative demand This should lower demand for money and raise the price level Higher price should depreciate the exchange rate Example Money demand is Cobb-Douglas R −α Y 1+α with α = 0.2 and α∗ = 0.4. The money supply is M = 90, M ∗ = 70 and Y = 150, Y ∗ = 100. The interest rate is R = 12 and R ∗ = 10 percent. Compute the exchange rate:
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate Raise R = 12 and thus lower the speculative demand This should lower demand for money and raise the price level Higher price should depreciate the exchange rate Example Money demand is Cobb-Douglas R −α Y 1+α with α = 0.2 and α∗ = 0.4. The money supply is M = 90, M ∗ = 70 and Y = 150, Y ∗ = 100. The interest rate is R = 12 and R ∗ = 10 percent. Compute the exchange rate: Answer:
90/[0.12−0.2 (1501.2 )] 70/[0.1−0.4 (1001.4 )]
Bill Gibson
= 3.26
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate In Keynesian world higher interest rate should appreciate the currency
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate In Keynesian world higher interest rate should appreciate the currency ˆ − Lˆ P = M/L → Pˆ = M
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate In Keynesian world higher interest rate should appreciate the currency ˆ − Lˆ P = M/L → Pˆ = M Lˆ = −αRˆ
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate In Keynesian world higher interest rate should appreciate the currency ˆ − Lˆ P = M/L → Pˆ = M Lˆ = −αRˆ So Pˆ = −αRˆ
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate In Keynesian world higher interest rate should appreciate the currency ˆ − Lˆ P = M/L → Pˆ = M Lˆ = −αRˆ So Pˆ = −αRˆ Real interest rate = R − pˆ = R − αRˆ
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate In Keynesian world higher interest rate should appreciate the currency ˆ − Lˆ P = M/L → Pˆ = M Lˆ = −αRˆ So Pˆ = −αRˆ Real interest rate = R − pˆ = R − αRˆ Example What happens to the price level when the rate of interest goes from 10 to 12 percent. Income is 150 and the money supply is 90 and the demand for money is R −α Y 1+α with α = 0.2
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
PPP Exchange rate In Keynesian world higher interest rate should appreciate the currency ˆ − Lˆ P = M/L → Pˆ = M Lˆ = −αRˆ So Pˆ = −αRˆ Real interest rate = R − pˆ = R − αRˆ Example What happens to the price level when the rate of interest goes from 10 to 12 percent. Income is 150 and the money supply is 90 and the demand for money is R −α Y 1+α with α = 0.2 Answer: Prices rise from 0.139 to 0.144 or 3.6 percent. The real interest rate then fell from 10 to 12 − 3.6 = 8.4 percent Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Fisher effect The Fisher effect: a rise in the domestic inflation rate causes an equal rise in the interest rate on deposits of domestic currency in the long run, when other factors remain constant.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Fisher effect The Fisher effect: a rise in the domestic inflation rate causes an equal rise in the interest rate on deposits of domestic currency in the long run, when other factors remain constant. Comes from the idea that the real rate of interest is determined by preferences
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Fisher effect The Fisher effect: a rise in the domestic inflation rate causes an equal rise in the interest rate on deposits of domestic currency in the long run, when other factors remain constant. Comes from the idea that the real rate of interest is determined by preferences rr = r − pˆ (be careful about applying hats to interest rates)
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Fisher effect The Fisher effect: a rise in the domestic inflation rate causes an equal rise in the interest rate on deposits of domestic currency in the long run, when other factors remain constant. Comes from the idea that the real rate of interest is determined by preferences rr = r − pˆ (be careful about applying hats to interest rates) Fisher effect is behind yield curve: government bonds pay lower interest rate in the short run and higher in the long run.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Fisher effect The Fisher effect: a rise in the domestic inflation rate causes an equal rise in the interest rate on deposits of domestic currency in the long run, when other factors remain constant. Comes from the idea that the real rate of interest is determined by preferences rr = r − pˆ (be careful about applying hats to interest rates) Fisher effect is behind yield curve: government bonds pay lower interest rate in the short run and higher in the long run. Example If US has 4 percent inflation and a nominal interest rate of 6 percent. Inflation heats up to 8 percent. In the long run the nominal r must be
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Fisher effect The Fisher effect: a rise in the domestic inflation rate causes an equal rise in the interest rate on deposits of domestic currency in the long run, when other factors remain constant. Comes from the idea that the real rate of interest is determined by preferences rr = r − pˆ (be careful about applying hats to interest rates) Fisher effect is behind yield curve: government bonds pay lower interest rate in the short run and higher in the long run. Example If US has 4 percent inflation and a nominal interest rate of 6 percent. Inflation heats up to 8 percent. In the long run the nominal r must be Answer: 10 percent (real interest rate constant at 2 percent) Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Empirical support for PPP Not strong for absolute
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Empirical support for PPP Not strong for absolute Prices of identical commodities differ between countries
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Empirical support for PPP Not strong for absolute Prices of identical commodities differ between countries More support for relative but doesn’t determine exchange rates in real world
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Empirical support for PPP Not strong for absolute Prices of identical commodities differ between countries More support for relative but doesn’t determine exchange rates in real world Better in the long run
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Empirical support for PPP Not strong for absolute Prices of identical commodities differ between countries More support for relative but doesn’t determine exchange rates in real world Better in the long run Trade barriers (tariff and non-tariff)
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Empirical support for PPP Not strong for absolute Prices of identical commodities differ between countries More support for relative but doesn’t determine exchange rates in real world Better in the long run Trade barriers (tariff and non-tariff) Imperfect competition
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Empirical support for PPP Not strong for absolute Prices of identical commodities differ between countries More support for relative but doesn’t determine exchange rates in real world Better in the long run Trade barriers (tariff and non-tariff) Imperfect competition Example If the tariff lines are constant but the environmental protection agency increases its enforcement in Mexico but not the U.S., the PPP of the peso will
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Empirical support for PPP Not strong for absolute Prices of identical commodities differ between countries More support for relative but doesn’t determine exchange rates in real world Better in the long run Trade barriers (tariff and non-tariff) Imperfect competition Example If the tariff lines are constant but the environmental protection agency increases its enforcement in Mexico but not the U.S., the PPP of the peso will Answer: Decline Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Dollar/yen exchange and inflation rates
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate Started with idea that a rise in the interest rate would attract foreign capital because return is higher.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate Started with idea that a rise in the interest rate would attract foreign capital because return is higher. Under fixed exchange rates, capital flows abroad if risk is not too great.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate Started with idea that a rise in the interest rate would attract foreign capital because return is higher. Under fixed exchange rates, capital flows abroad if risk is not too great. Country could attract foreign capital by raising its interest rate.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate Started with idea that a rise in the interest rate would attract foreign capital because return is higher. Under fixed exchange rates, capital flows abroad if risk is not too great. Country could attract foreign capital by raising its interest rate. As capital flows abroad exchange rates appreciates and this increases the incentive for capital to flow abroad.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate Started with idea that a rise in the interest rate would attract foreign capital because return is higher. Under fixed exchange rates, capital flows abroad if risk is not too great. Country could attract foreign capital by raising its interest rate. As capital flows abroad exchange rates appreciates and this increases the incentive for capital to flow abroad. Country has control over interest rate by way of money supply
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate Started with idea that a rise in the interest rate would attract foreign capital because return is higher. Under fixed exchange rates, capital flows abroad if risk is not too great. Country could attract foreign capital by raising its interest rate. As capital flows abroad exchange rates appreciates and this increases the incentive for capital to flow abroad. Country has control over interest rate by way of money supply Tightening money supply raises in the interest rate
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate Started with idea that a rise in the interest rate would attract foreign capital because return is higher. Under fixed exchange rates, capital flows abroad if risk is not too great. Country could attract foreign capital by raising its interest rate. As capital flows abroad exchange rates appreciates and this increases the incentive for capital to flow abroad. Country has control over interest rate by way of money supply Tightening money supply raises in the interest rate Foreign capital flows in
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate Started with idea that a rise in the interest rate would attract foreign capital because return is higher. Under fixed exchange rates, capital flows abroad if risk is not too great. Country could attract foreign capital by raising its interest rate. As capital flows abroad exchange rates appreciates and this increases the incentive for capital to flow abroad. Country has control over interest rate by way of money supply Tightening money supply raises in the interest rate Foreign capital flows in This is the standard argument ↓ M/P =⇒↑ R =⇒↓ E
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate Started with idea that a rise in the interest rate would attract foreign capital because return is higher. Under fixed exchange rates, capital flows abroad if risk is not too great. Country could attract foreign capital by raising its interest rate. As capital flows abroad exchange rates appreciates and this increases the incentive for capital to flow abroad. Country has control over interest rate by way of money supply Tightening money supply raises in the interest rate Foreign capital flows in This is the standard argument ↓ M/P =⇒↑ R =⇒↓ E Impossible under the Monetary Approach Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
Milton Friedman: U of Chicago and Friedrich von Hayek
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
Milton Friedman: U of Chicago and Friedrich von Hayek Now impossible for this to happen
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
Milton Friedman: U of Chicago and Friedrich von Hayek Now impossible for this to happen Real interest rate not set by govt but by preferences
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
Milton Friedman: U of Chicago and Friedrich von Hayek Now impossible for this to happen Real interest rate not set by govt but by preferences Govt impotent to change interest rate
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
Milton Friedman: U of Chicago and Friedrich von Hayek Now impossible for this to happen Real interest rate not set by govt but by preferences Govt impotent to change interest rate If try to cut money supply, then prices fall
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
Milton Friedman: U of Chicago and Friedrich von Hayek Now impossible for this to happen Real interest rate not set by govt but by preferences Govt impotent to change interest rate If try to cut money supply, then prices fall Prices fall immediately
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
Milton Friedman: U of Chicago and Friedrich von Hayek Now impossible for this to happen Real interest rate not set by govt but by preferences Govt impotent to change interest rate If try to cut money supply, then prices fall Prices fall immediately Real value of money supply doesn’t change
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
Milton Friedman: U of Chicago and Friedrich von Hayek Now impossible for this to happen Real interest rate not set by govt but by preferences Govt impotent to change interest rate If try to cut money supply, then prices fall Prices fall immediately Real value of money supply doesn’t change A one shot change in M has no effect on anything
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
What if the country keeps trying to raise money supply?
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
What if the country keeps trying to raise money supply? ˆ Instead of changing M, change M?
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
What if the country keeps trying to raise money supply? ˆ Instead of changing M, change M? Real interest rate still set by preferences
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
What if the country keeps trying to raise money supply? ˆ Instead of changing M, change M? Real interest rate still set by preferences Govt impotent to change real interest rate
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
What if the country keeps trying to raise money supply? ˆ Instead of changing M, change M? Real interest rate still set by preferences Govt impotent to change real interest rate If try to cut money supply, then prices fall deflation
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
What if the country keeps trying to raise money supply? ˆ Instead of changing M, change M? Real interest rate still set by preferences Govt impotent to change real interest rate If try to cut money supply, then prices fall deflation Prices fall continuously
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
What if the country keeps trying to raise money supply? ˆ Instead of changing M, change M? Real interest rate still set by preferences Govt impotent to change real interest rate If try to cut money supply, then prices fall deflation Prices fall continuously Real value of money supply doesn’t change
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate
What if the country keeps trying to raise money supply? ˆ Instead of changing M, change M? Real interest rate still set by preferences Govt impotent to change real interest rate If try to cut money supply, then prices fall deflation Prices fall continuously Real value of money supply doesn’t change A continuous change in M has an effect on the nominal interest rate
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate In Friedman and von Hayek’s world govt has no power over real variables-only nominal
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate In Friedman and von Hayek’s world govt has no power over real variables-only nominal Constant growth of M cause nominal interest rate to fall by the amount of Pˆ from quantity equation
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate In Friedman and von Hayek’s world govt has no power over real variables-only nominal Constant growth of M cause nominal interest rate to fall by the amount of Pˆ from quantity equation Fisher Effect: inflation causes nominal interest rate to rise and vice versa.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate In Friedman and von Hayek’s world govt has no power over real variables-only nominal Constant growth of M cause nominal interest rate to fall by the amount of Pˆ from quantity equation Fisher Effect: inflation causes nominal interest rate to rise and vice versa. Real interest rate remains fixed.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate In Friedman and von Hayek’s world govt has no power over real variables-only nominal Constant growth of M cause nominal interest rate to fall by the amount of Pˆ from quantity equation Fisher Effect: inflation causes nominal interest rate to rise and vice versa. Real interest rate remains fixed. Economic agents only motivated by real variables
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate In Friedman and von Hayek’s world govt has no power over real variables-only nominal Constant growth of M cause nominal interest rate to fall by the amount of Pˆ from quantity equation Fisher Effect: inflation causes nominal interest rate to rise and vice versa. Real interest rate remains fixed. Economic agents only motivated by real variables Example The nominal interest rate R = 3 percent. If inflation jumped from zero to Pˆ = 12 percent what would happen to the nominal inflation rate?
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Monetary Approach to Exchange Rate In Friedman and von Hayek’s world govt has no power over real variables-only nominal Constant growth of M cause nominal interest rate to fall by the amount of Pˆ from quantity equation Fisher Effect: inflation causes nominal interest rate to rise and vice versa. Real interest rate remains fixed. Economic agents only motivated by real variables Example The nominal interest rate R = 3 percent. If inflation jumped from zero to Pˆ = 12 percent what would happen to the nominal inflation rate? Answer: Would rise to 15 percent. Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved A rise in the interest rate with no increase in the price level attracts foreign capital as we have said.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved A rise in the interest rate with no increase in the price level attracts foreign capital as we have said. If the rise in the nominal interest rate is the result of increasing inflation in that country then foreign capital will not flow in.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved A rise in the interest rate with no increase in the price level attracts foreign capital as we have said. If the rise in the nominal interest rate is the result of increasing inflation in that country then foreign capital will not flow in. Why does an investor care about the inflation in the foreign country in which she is investing her capital?
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved A rise in the interest rate with no increase in the price level attracts foreign capital as we have said. If the rise in the nominal interest rate is the result of increasing inflation in that country then foreign capital will not flow in. Why does an investor care about the inflation in the foreign country in which she is investing her capital? She wants to earn the high interest there and bring the money back to spend it!
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved A rise in the interest rate with no increase in the price level attracts foreign capital as we have said. If the rise in the nominal interest rate is the result of increasing inflation in that country then foreign capital will not flow in. Why does an investor care about the inflation in the foreign country in which she is investing her capital? She wants to earn the high interest there and bring the money back to spend it! She does not care about the foreign inflation because it will not affect her
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved A rise in the interest rate with no increase in the price level attracts foreign capital as we have said. If the rise in the nominal interest rate is the result of increasing inflation in that country then foreign capital will not flow in. Why does an investor care about the inflation in the foreign country in which she is investing her capital? She wants to earn the high interest there and bring the money back to spend it! She does not care about the foreign inflation because it will not affect her ...or will it? Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Let’s she is expecting a devaluation in her own country
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Let’s she is expecting a devaluation in her own country That is why she is investing abroad in the first place
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Let’s she is expecting a devaluation in her own country That is why she is investing abroad in the first place Foreign inflation will cancel out the advantage
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Let’s she is expecting a devaluation in her own country That is why she is investing abroad in the first place Foreign inflation will cancel out the advantage It will cause her home country currency to appreciate!
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Let’s she is expecting a devaluation in her own country That is why she is investing abroad in the first place Foreign inflation will cancel out the advantage It will cause her home country currency to appreciate! Summarize this by saying: higher nominal interest rates in a world with PPP (LOP) will not attract foreign capital in the long run
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Let’s she is expecting a devaluation in her own country That is why she is investing abroad in the first place Foreign inflation will cancel out the advantage It will cause her home country currency to appreciate! Summarize this by saying: higher nominal interest rates in a world with PPP (LOP) will not attract foreign capital in the long run Higher real interest rates will but government is powerless to affect real interest rates
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Let’s she is expecting a devaluation in her own country That is why she is investing abroad in the first place Foreign inflation will cancel out the advantage It will cause her home country currency to appreciate! Summarize this by saying: higher nominal interest rates in a world with PPP (LOP) will not attract foreign capital in the long run Higher real interest rates will but government is powerless to affect real interest rates LOP holds because of arbitrage
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Let’s she is expecting a devaluation in her own country That is why she is investing abroad in the first place Foreign inflation will cancel out the advantage It will cause her home country currency to appreciate! Summarize this by saying: higher nominal interest rates in a world with PPP (LOP) will not attract foreign capital in the long run Higher real interest rates will but government is powerless to affect real interest rates LOP holds because of arbitrage Inflation is a good reason to expect future devaluation Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved A rise in the interest rate with no increase in the price level attracts foreign capital as we have said.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved A rise in the interest rate with no increase in the price level attracts foreign capital as we have said. If the rise in the nominal interest rate is the result of increasing inflation in that country then foreign capital will not flow in.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved A rise in the interest rate with no increase in the price level attracts foreign capital as we have said. If the rise in the nominal interest rate is the result of increasing inflation in that country then foreign capital will not flow in. Why does an investor care about the inflation in the foreign country in which she is investing her capital?
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved A rise in the interest rate with no increase in the price level attracts foreign capital as we have said. If the rise in the nominal interest rate is the result of increasing inflation in that country then foreign capital will not flow in. Why does an investor care about the inflation in the foreign country in which she is investing her capital? She wants to earn the high interest there and bring the money back to spend it!
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved A rise in the interest rate with no increase in the price level attracts foreign capital as we have said. If the rise in the nominal interest rate is the result of increasing inflation in that country then foreign capital will not flow in. Why does an investor care about the inflation in the foreign country in which she is investing her capital? She wants to earn the high interest there and bring the money back to spend it! Why does she care about foreign inflation?
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Example What stops a foreign investor from moving money abroad when the the foreign nominal interest rate is higher than the domestic.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Example What stops a foreign investor from moving money abroad when the the foreign nominal interest rate is higher than the domestic. Answer: Contradicts PPP (LOP) says that it will be impossible to only have inflation in one country. If so, the exchange rate will simply devalue to compensate. Raising interest rates will not work!
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Example What stops a foreign investor from moving money abroad when the the foreign nominal interest rate is higher than the domestic. Answer: Contradicts PPP (LOP) says that it will be impossible to only have inflation in one country. If so, the exchange rate will simply devalue to compensate. Raising interest rates will not work! Example An increase in the money supply will cause a fall in the real rate of interest. Imports will rise and the real exchange will
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved Example What stops a foreign investor from moving money abroad when the the foreign nominal interest rate is higher than the domestic. Answer: Contradicts PPP (LOP) says that it will be impossible to only have inflation in one country. If so, the exchange rate will simply devalue to compensate. Raising interest rates will not work! Example An increase in the money supply will cause a fall in the real rate of interest. Imports will rise and the real exchange will Answer: depreciate Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox Resolved
To formally resolve the paradox appeal to sticky prices
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox Resolved
To formally resolve the paradox appeal to sticky prices With sticky prices ↓ M/P =⇒↑ R =⇒↓ E
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox Resolved
To formally resolve the paradox appeal to sticky prices With sticky prices ↓ M/P =⇒↑ R =⇒↓ E Prices cannot be sticky in the long run
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox Resolved
To formally resolve the paradox appeal to sticky prices With sticky prices ↓ M/P =⇒↑ R =⇒↓ E Prices cannot be sticky in the long run Then a rise in the nominal interest rate is not an rise in the real interest rate and so ↓ M/P =⇒↑ Rnom =⇒↑ E
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox Resolved
To formally resolve the paradox appeal to sticky prices With sticky prices ↓ M/P =⇒↑ R =⇒↓ E Prices cannot be sticky in the long run Then a rise in the nominal interest rate is not an rise in the real interest rate and so ↓ M/P =⇒↑ Rnom =⇒↑ E The depreciation cancels out the attractiveness of the interest rate increase
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox Resolved
To formally resolve the paradox appeal to sticky prices With sticky prices ↓ M/P =⇒↑ R =⇒↓ E Prices cannot be sticky in the long run Then a rise in the nominal interest rate is not an rise in the real interest rate and so ↓ M/P =⇒↑ Rnom =⇒↑ E The depreciation cancels out the attractiveness of the interest rate increase Monetary Approach-PPP(LOP) only holds in the long run
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved
This is one reason some people are against foreign capital flows
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved
This is one reason some people are against foreign capital flows They are not sustainable
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved
This is one reason some people are against foreign capital flows They are not sustainable Rising nominal interest rate are not real...cause hot money
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved
This is one reason some people are against foreign capital flows They are not sustainable Rising nominal interest rate are not real...cause hot money Assumptions of Monetary Approach very strong!
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved
This is one reason some people are against foreign capital flows They are not sustainable Rising nominal interest rate are not real...cause hot money Assumptions of Monetary Approach very strong! Long run may never arrive!
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved
This is one reason some people are against foreign capital flows They are not sustainable Rising nominal interest rate are not real...cause hot money Assumptions of Monetary Approach very strong! Long run may never arrive! In the long run we’re all dead! J.M. Keynes
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Paradox resolved
This is one reason some people are against foreign capital flows They are not sustainable Rising nominal interest rate are not real...cause hot money Assumptions of Monetary Approach very strong! Long run may never arrive! In the long run we’re all dead! J.M. Keynes Most policy made in the short run...assuming sticky prices.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real exchange rate Takes into account real and nominal effects
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real exchange rate Takes into account real and nominal effects Real exchange rate q=
Bill Gibson
EP ∗ P
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real exchange rate Takes into account real and nominal effects Real exchange rate q=
EP ∗ P
Example GDP deflator = 116 in U.S. and 143.2 in Mexico. The nominal exchange rate is 12 pesos per USD. What is the real exchange rate for US
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real exchange rate Takes into account real and nominal effects Real exchange rate q=
EP ∗ P
Example GDP deflator = 116 in U.S. and 143.2 in Mexico. The nominal exchange rate is 12 pesos per USD. What is the real exchange rate for US Answer:
12(143.2) 116
= 14.81
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real exchange rate Now take hats qˆ = Eˆ + Pˆ ∗ − Pˆ
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real exchange rate Now take hats qˆ = Eˆ + Pˆ ∗ − Pˆ
Example If US has 10 percent inflation and Canada has 6 percent inflation but the real exchange rate is constant, what is rate of change in the nominal exchange rate
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real exchange rate Now take hats qˆ = Eˆ + Pˆ ∗ − Pˆ
Example If US has 10 percent inflation and Canada has 6 percent inflation but the real exchange rate is constant, what is rate of change in the nominal exchange rate Answer: 4 percent devaluation of the US currency relative to Canada.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real exchange rate Now take hats qˆ = Eˆ + Pˆ ∗ − Pˆ
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real exchange rate Now take hats qˆ = Eˆ + Pˆ ∗ − Pˆ
Example France has 3 percent nominal devaluation after experiencing a 6 percent rate inflation. The world rate of inflation is 3 percent. France’s competitiveness has
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real exchange rate Now take hats qˆ = Eˆ + Pˆ ∗ − Pˆ
Example France has 3 percent nominal devaluation after experiencing a 6 percent rate inflation. The world rate of inflation is 3 percent. France’s competitiveness has Answer: Not changed! Their real exchange rate is constant. qˆ = 3 + 3 − 6 = 0
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
How real exchange rate works US exports computers
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
How real exchange rate works US exports computers Mexico exports tortillas
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
How real exchange rate works US exports computers Mexico exports tortillas Real exchange rate qˆ = Eˆ + pˆ ∗ − pˆ =
Bill Gibson
$ peso
pesos tortilla $ computer
=
University of Vermont
computer tortilla
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
How real exchange rate works US exports computers Mexico exports tortillas Real exchange rate qˆ = Eˆ + pˆ ∗ − pˆ =
$ peso
pesos tortilla $ computer
=
computer tortilla
Example If the US has to give two computers per ton of tortillas instead of one, is the US better off or worse off.
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
How real exchange rate works US exports computers Mexico exports tortillas Real exchange rate qˆ = Eˆ + pˆ ∗ − pˆ =
$ peso
pesos tortilla $ computer
=
computer tortilla
Example If the US has to give two computers per ton of tortillas instead of one, is the US better off or worse off. Answer: This is real devaluation of the dollar. US exporters are more competitive, but importers are worse off. Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Example-Dutch Disease
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Tariffs Quotas
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
General model
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real Exchange Rate
Example If the US inflation rate is expected to exceed that of the UK by 5 percent. If the real rate of depreciation is 2 percent, what must happen to the nominal exchange rate?
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Real Exchange Rate
Example If the US inflation rate is expected to exceed that of the UK by 5 percent. If the real rate of depreciation is 2 percent, what must happen to the nominal exchange rate? Answer: Use qˆ = Eˆ + pˆ ∗ − pˆ which gives 2 = Eˆ - 5. → Eˆ = 7
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Complete Model L(R, Y ) = M/P )
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Complete Model L(R, Y ) = M/P ) E =
F R −R ∗ +1
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Complete Model L(R, Y ) = M/P ) E =
F R −R ∗ +1
Mv = pY
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Complete Model L(R, Y ) = M/P ) E =
F R −R ∗ +1
Mv = pY q = EP ∗ /P
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Complete Model L(R, Y ) = M/P ) E =
F R −R ∗ +1
Mv = pY q = EP ∗ /P σ = wL/PY = wr /ρ
Bill Gibson
University of Vermont
LOP-PPP Monetary Approach to Exchange Rate Real Exchange Rate
Complete Model L(R, Y ) = M/P ) E =
F R −R ∗ +1
Mv = pY q = EP ∗ /P σ = wL/PY = wr /ρ Where Y = real income, M = money supply r = dom interest rate, r ∗ = v = velocity of money, foreign interest rate, F = future rate, e = nominal (spot) exchange rate, L = employment, P =dom price level, P ∗ =foreign price level,q = real exchange rate, w = nominal wage rate, L = employment, wr real wage, ρ = productivity
Bill Gibson
University of Vermont
