Exchange Rates and Purchasing Power Parity

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Exchange Rates and Purchasing Power Parity

• CHAPTER 13

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Introduction

• Exchange rates matter in many different ways to
  many different constituencies in the world
  economy
• Much of this section on international finance
  will be directly or indirectly concerned with
  exchange rates

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The Nominal Exchange Rate

• Relative price of two currencies
• Often expressed as number of units of local or
  home currency required to buy a unit of foreign
  currency
• We will usually view Mexico (peso) as our home
  country and United States (dollar) as our foreign
  country
• Nominal or currency exchange rate (e) is

• If e increases the value of the peso (home
  currency) falls
• If e decreases the value of the peso (home
  currency) rises
• e and the value of the peso are inversely related
• e is often graphed as its inverse which is equal
  to the value of the peso

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Table 13.1. Nominal Exchange Rates, October 9,
2002 (per US dollar)
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Figure 13.1. The Value of the Peso Scale
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The Real Exchange Rate

• Measures the rate at which two countries goods
  trade against each other
• Makes use of the price levels in the two
  countries under consideration
• PMoverall price level in Mexico (the home
  country)
• PUSoverall price level in the United States (the
  foreign country)

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Table 13.2. Changes in the Real Exchange Rate
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The Real Exchange Rate

• Suppose that the price level in the United States
  rises
• Takes more Mexican goods to purchase US goods
• Represents a fall in the real value of the peso
• Suppose that the price level in Mexico rises
• Takes fewer Mexican goods to purchase US goods
• Represents a rise in the real value of the peso
• Suppose that the nominal exchange rate increases
• Takes more Mexican pesos to buy a US dollar and,
  therefore, more Mexican goods to buy US goods
• Represents a fall in the real value of the peso
• Real exchange rates affected by both nominal
  exchange rates and price levels

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Exchange Rates and Trade Flows

• Changes in e have an impact on trade flows
• Consider the case of Mexicos imports and exports
• World prices (PW) are typically in US dollar
  terms
• Mexican prices (PM) are in peso terms
• Relationship between the peso and world prices of
  Mexicos import (Z) goods can be expressed as

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Exchange Rates and Trade Flows

• Suppose e were to increase (the value of the peso
  falls)
• Movement down the scale in Figure 13.1 increases
  the peso price of the imported good in Mexico
• Import demand consequently decreases
• Suppose e were to decrease (the value of the peso
  rises)
• Movement up the scale in Figure 13.1 decreases
  the peso price of the imported good in Mexico
• Import demand consequently increases

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Figure 13.2. The Value of the Peso and Mexicos
Imports
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Figure 13.3. The Value of the Peso and Mexicos
Exports
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Exchange Rates and Trade Flows

• Relationship between the peso and dollar prices
  of Mexicos exported (E) goods can be expressed as

• Suppose e were to increase (the value of the peso
  falls)
• Movement down the scale in Figure 13.1 increases
  the peso price of the export good in Mexico
• Export supply in Mexico consequently increases
• Mexican firms now have more of an incentive in
  peso terms to export

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Exchange Rates and Trade Flows

• Suppose e were to decrease (the value of the peso
  rises)
• Movement up the inverse scale in Figure 13.1
  decreases the peso price of exports in Mexico
• Export supply consequently decreases
• Can put the relationships of Figures 13.2 and
  13.3 together
• Figure 13.4 represents the positive relationship
  between value of peso and trade deficit, or Z E

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Figure 13.4. The Value of the Peso and Mexicos
Trade Deficit
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The Purchasing Power Parity Model

• Begins with the hypothesis that the nominal
  exchange rate will adjust so that the purchasing
  power of a currency will be the same in every
  country
• Implications of hypothesis
• Purchasing power of a currency in a given country
  is inversely related to price level in that
  country
• For example, purchasing power of the peso in
  Mexico can be expressed as

• The higher the price level in Mexico the lower
  the purchasing power of the peso
• Purchasing power of peso in United States is more
  complicated
• Need rate at which a peso can be exchanged into
  dollars, or 1/e
• Need purchasing power of a dollar in United
  States, or 1/PUS
• Purchasing power of a peso in United States is

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PPP Equation

• PPP hypothesis is

• Invert the equation

• Divide both sides of the above equation by PUS to
  obtain PPP equation

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Meaning of PPP Equation

• Suppose PM were to increase
• According to the PPP model, e would increase
• Value of the peso would move down the scale in
  Figure 13.1
• Suppose PUS were to increase
• According to the PPP model e would decrease
• Value of the peso would move up the scale in
  Figure 13.1
• Nominal value of the peso adjusts to changes in
  its real purchasing power in the two countries

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Meaning of PPP Equation

• Restrictiveness of PPP model can be seen when we
  re-express it in a third equation
• Multiplying both sides of the PPP equation by

• Obtain modified PPP equation

• Compare this equation with real exchange rate

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PPP Model as Special Case

• PPP model is a special case of the real exchange
  rate
• Implies that real exchange rate is fixed at unity
• No change in real exchange rate
• However real exchange rates do change therefore
  there must be important elements of the real
  world that the PPP theory ignores
• PPP assumes all goods entering into the price
  levels of both countries are internationally
  traded
• Phenomenon of product differentiation
• Allows for separate markets (and therefore
  prices) for import and domestic varieties of a
  good

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PPP Model as Special Case

• Real exchange rate equation captures reality at
  any point in time
• PPP relationship never holds exactly
• PPP equation gives a sense of a long-term
  tendency towards which nominal exchange rates
  move absent other changes

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Exchange Rate Exposure

• If sales from either exporting or foreign direct
  investment are not denominated in the currencies
  of the firms home countries
• Exchange rate exposure issues arise
• Suppose that the /US exchange rate is currently
  at a value of 1.00
• Suppose also that a US firm is expecting euro
  revenues of 1.0 million
• Current exchange rate (spot rate) suggests US
  firm might be expecting dollar revenues of US1.0
  million
• Suppose, however, that the spot rate moves to e
  1.25 (a dollar value of the euro of 0.80)
• Now takes more euros to purchase a dollardollar
  revenues shrink to 800,000

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Forward Markets

• For some currencies forward rates also exist
• Rates of current contracts for forward
  transactions in currencies
• Usually for one, three, or six months in the
  future
• If the forward rate of the euro (/US) is
  exactly the same as the spot rate
• Euro is flat
• If the forward rate of the euro is above the spot
  rate
• Euro is at a forward discount
• If the forward rate of the euro is below the spot
  rate
• Euro is at a forward premium
• Hedging exchange rate exposure requires that
  firms have expectations or forecasts of future
  spot rates that they can compare to forward rates