Money and the Exchange Rate in the Long Run

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Money and the Exchange Rate in the Long Run

• In the long run
• Prices are flexible
• As a first approximation, lets assume PPP holds
• Pdomestic price level Pforeign price level
• Equilibrium in the money market
  PPP
• If M?, P?, E?
• If L?, P?, E?

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Case Study Money Supply Growth in Bolivia

• Hyperinflation inflation rate of 50 a month or
  higher
• Bolivia experienced hyperinflation between April
  1984 and October 1985
• During hyperinflations, the long-run effects of
  money on the price level occur very quickly

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Money growth, Inflation and Depreciation in
Bolivia 1984-85
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Money growth, Inflation and Depreciation in OECD
economies
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Money and the Exchange Rate in the Short Run

• In the short run the price level is fixed (strong
  assumption)
• If M?, L?
• How can money demand fall?
• Money has no effect on output in the long run,
  i.e. Yf is not affected by M
• Hence, R?

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Money and the Exchange Rate in the Short Run,
cont.

• UIPC
• R R (Ee - E)/E
• E adjusts instantaneously to achieve UIPC
• Suppose M? permanently
• Ee ? (long-run effect)
• Given R, if R?, this implies (Ee - E)/E ?
• Hence, E ? more than Ee?
• This is the exchange rate overshooting

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A Long-Run Exchange Rate Model Based on PPP

• PPP
• ECHF/ PCHF/ P
• Differentiate to obtain relative PPP
• (EeCHF/ - ECHF/)/ECHF/ ?eCHF - ?e
• Expected depreciation of the Swiss Franc relative
  to the Euro expected inflation differential
• UIPC
• RCHF R (EeCHF/ - ECHF/ ) / ECHF/
• Combine relative PPP with UIPC to obtain the
  Fisher relationship
• RCHF - R (EeCHF/ - ECHF/)/ECHF/ ?eCHF
  - ?e
• The international interest rate differential is
  the difference between expected national
  inflation rates

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Empirical Evidence on the Fisher Relationship
Switzerland
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Empirical Evidence on the Fisher Relationship
The United States
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Empirical Evidence on the Fisher Relationship
Switzerland and the United States
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Empirical Evidence on the Fisher Relationship
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Does PPP Really Hold in the Long Run? For All
Goods?

• It does, but in the very long run
• The speed of convergence is very slow deviations
  appear to damp out at a rate of roughly 15 per
  year

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Empirical Evidence on PPP and the Law of One
Price

• Big Mac Currencies, published by The Economist
• Started in 1986 it is a survey of Big Mac
  hamburger prices at McDonalds restaurants around
  the world
• It is a homogeneous good. Hence the Law of One
  Price would apply
• Evidence The Economist

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Big Mac

• Column 1 Big Mac price in local currency Px
• Column 2 Px multiplied by E/x, the U.S.
  dollar/local currency price exchange rate. This
  is the dollar price of the Big Mac in country X
• Column 3 Px/ PUS. This is the implied PPP of
  the U.S. dollar, EPPP/X
• Column 3 (EPPP/X - E/X)100 / E/X
• This is the under(-)/over() valuation of
  currency X against the U.S. dollar
• The CHF is 53 overvalued relative to the US
  Dollar

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Big Mac (cont.)

• China most undervalued, Iceland the most
  overvalued
• If you can keep the Big Mac fresh, buy it in
  China for the equivalent of 1.45 and sell it in
  Iceland for 7.6!
• Trade barriers, transport costs and differences
  in taxes
• Use of non-traded goods and services, like labor
  and rent contribute about 60 of the price of the
  Big Mac
• Most expensive Big Mac Iceland, Norway,
  Switzerland, Denmark
• Least expensive Big Mac Sri Lanka, Indonesia,
  Hong Kong

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Explaining the Problems with PPP

• The failure of the empirical evidence to support
  the PPP and the law of one price is related to
• Trade barriers and transport costs
• Non-tradable goods
• Departures from free competition
• International differences in price level
  measurement

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Trade Barriers and Transport Costs

• Transport costs and governmental trade
  restrictions make trade expensive
• Equivalent to 170 tariff in advanced economies

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Non-tradable goods

• The domestic prices of non-tradable goods can be
  very different when expressed in the same
  currency
• Example housing price in Lausanne and in New
  Delhi
• No arbitrage
• Non-tradable goods account for about 50 of GNP
  and hence 50 of the CPI
• Non-tradable goods are more expensive in richer
  countries

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Balassa-Samuelson Hypothesis

• In poorer countries, productivity in tradable
  goods and therefore wages are lower
• Prices of non-tradable goods are lower
• PN gt E PN
• Where PN is the foreign price of non-tradable
  goods
• Because non-tradable goods account for almost 50
  of the CPI (consumer price index)
• P gt E P

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Price Levels and GDP per capita