ch3_international econ.pdf
Transcript of ch3_international econ.pdf
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Exchange Rates and Prices in the Long Run
2 Money, Prices, and
Exchange Rates in the Long Run
3 The Monetary
A h
EXCHANGE RATES I: THE MONETARY
APPROACH IN THE Approach
4 Money, Interest, and
Prices in the Long Run5
Monetary Regimes and Exchange Rate
Regimes6
Conclusions
LONG RUN
Chapter Outline
1. Exchange Rates and Prices in the Long Run2. Money, Prices and Exchange Rates in the Long
RunRun3. The Monetary Approach4. Money, Interest, and Prices in the Long Run5. Monetary Regimes and Exchange Rate Regimes
Today: topic 1
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Today: topic 1
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Chapter outline
Examples of questions we will address in this lecture:
Is the Chinese Renminbi undervalued? How large is Chinese GDP relative to US GDP? If there is more inflation in the US than in the Euro
zone, how should this affect the $/ exchange
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grate in the long run?
1. Exchange Rates and Prices in the Long Run
The notion of arbitrage Chapter 2: applied there to currencies and interest rates Chapter 2: applied there to currencies and interest rates Chapter 3: applied here to goods
The foundation of this theory is the fundamental arbitrage principle known as the law of one price (LOOP)
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(LOOP).
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The Law of One Price
Key assumption: frictionless trade No transaction costs No barriers to tradeNo barriers to trade Identical goods in each location
Law of One Price (LOOP):
The prices of a given good must be equal in all locations when expressed in a common currency
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locations when expressed in a common currency. Otherwise, there would be a profit opportunity from
buying low and selling high (arbitrage).
The Law of One Price
Is the LOOP true in the data? 2009, in US $
Source: Economist Intelligence Unit.
Abidjan Amsterdam Beijing HongKong Geneva TehranDomesticcleaning(1hr) 4.34 15.71 4.39 12.9 25.23 3.52
Oranges(1kg) 1.3 2.57 2.87 2.26 2.99 1.81
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Measuring International Price Differences
We would like to measure the extent to which goods are more expensive in one country than in another. Look at basket of goods.g
Real exchange rate
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Analogous to nominal exchange rate but note keydifference: goods rather than currencies.
The Real Exchange Rate
Real exchange rate appreciation, depreciation
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The Real Exchange Rate
How is the real exchange rate measured?
Direct comparison of prices of goods Direct comparison of prices of goods
As an index, whose variations are given by
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Multilateral effective exchange rate
Real Exchange Rate in the Data
How does the real exchange rate behave in the data?data?
This depends a lot on the countries one looks at and the time period.
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Real Exchange Rate in the Data Between advanced economies, large real exchange rate
fluctuations in the short run, but q close to 1 in the medium to long run (absolute PPP).
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Real Exchange Rate in the Data
Absolute PPP:
Relative PPP:
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What Explains Deviations from PPP?
Transaction costs
Nontraded goods
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Price stickiness
What Explains Deviations from PPP?
Month-to-Month Variability of the Dollar/DM Exchange Rate and of the U.S./German Price-Level Ratio, 1974-2001
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How Fast is Convergence to PPP?
Two measures: Speed of convergence: how fast deviations from PPP
disappear over timedisappear over time 15% per year.
Half-life: how long it takes for half of the deviations from PPP to disappear (about four years).
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These estimates are useful for forecasting how long exchange rate adjustments will take.
Persistent deviations from PPP
Prices tend to be higher in rich countries
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Balassa-Samuelson effect.
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Balassa-Samuelson Effect
Bela Balassa (1928-1991)Paul Samuelson (1915-2009)
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The Big Mac Index
For over 20 years The Economist newspaper has compared Big Mac prices across countries.
The Economist asked correspondents around the world to visit McDonalds and get prices of a Big Mac, then compute price relative to the U.S.
Does this test PPP or LOOP?
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The Big Mac Index
Big Mac index = qBig Mac 1 = E$/local currencyPlocal
Big Mac
PUSBig Mac 1
The % deviation (+/) from the US price measures the over/under valuation of the local currency based on the burger basket. Updated every year:
http://www.economist.com/markets/Bigmac/
US
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p g In 2004 they tried the same exercise with another
global homogeneous product: the Starbucks tall latte.
Big Max Index (Feb. 4, 09)
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The Big Mac Index
Deviations from PPP and economic development
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Lets recap Real exchange rate:
Absolute PPP: q=1 (relative PPP: q constant) Absolute PPP applies in the medium to long run
between countries of same level of
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development. Persistent deviations from PPP between
countries with different levels of development (Balassa-Samuelson).
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Applications of PPP and exchange rates
Three applications:
I fl ti d i l h t d i ti Inflation and nominal exchange rate depreciation Measuring under- and overvaluations Comparing GDP across countries
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Application 1: Inflation and Nominal Exchange Rates
Consider 2 countries, A and B
Inflation higher in country B than in country A, g y y ,what does happen to the nominal exchange rate EB/A?
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Application 1: Inflation and Nominal Exchange Rates
Real exchange rate not affected by inflation differentials in the long run
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Application 2: Measuring Overvaluations and Undervaluations
By how much was the Chinese currency undervalued relative to the dollar in 2000?
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Application 2: Measuring Overvaluations and Undervaluations
In 2000, model prediction: equilibrium q = 0.319 versus actual q = 0.231 the Chinese c rrenc as nder al ed b 38% the Chinese currency was undervalued by 38%
Caveats
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Application 3: Comparing GDP Across Countries
In 2008, US GDP = bn$ 14,441
US GDP per capita= $47 440US GDP per capita= $47,440
Chinese GDP = bn$ 4,327 (30% of US level)Chinese GDP per capita= $3,259 (6.9% of US level)
( t k t h t )
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(at market exchange rate)
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Application 3: Comparing GDP Across Countries
But real exchange rate
q =0 546qC/US =0.546
So PPP-adjusted Chinese GDP
bn$ 4,327/ qC/US =bn$ 7,926 (55% of US level)
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Per capita: 12.6% of US level
Application 3: Comparing GDP Across Countries
Ratio of Chinese GDP to US GDP
0.6
0 2
0.3
0.4
0.5
market exchange rate
PPP-adjusted
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0
0.1
0.2
2000 2001 2002 2003 2004 2005 2006 2007 2008
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Application 3: Comparing GDP Across Countries
US GDP per capita as a multiple of Burundis & Bangladeshs
150
200
250
300
350
market rate
PPP adjusted
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0
50
100
Burundi Bangladesh