Exchange Rate Theories Chapters 6-8

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Questions and Answers

What does it indicate if the actual price of a dollar is lower than the Big Mac reference price?

It indicates that the dollar is undervalued and the euro is overvalued.

Why are prices for Big Macs not equalized perfectly across different countries?

Prices are distorted by taxes, price discrimination, and transportation costs.

How does the arbitrage mechanism work for iPods compared to Big Macs?

Arbitrage works better for iPods because they can be easily traded and the price is more consistent, showing better price alignment across markets.

What is the significance of the 27% euro overvaluation indicated by the iPod pricing compared to the Big Mac analysis?

It aligns with the Big Mac index, suggesting that both products reflect similar conclusions about currency valuation. Signup and view all the answers

What limitations does the Big Mac Index have when evaluating currency values?

The Big Mac Index is limited by various factors including taxes, price discrimination, and the inability to account for local market conditions. Signup and view all the answers

How does the concept of Purchasing Power Parity (PPP) influence the understanding of exchange rate undervaluation?

PPP suggests that exchange rates should adjust to reflect the relative price levels between countries; thus, an undervalued currency indicates that it buys less in foreign markets than domestic prices suggest. Signup and view all the answers

What are the key differences between absolute and relative PPP?

Absolute PPP focuses on the price level relationship, stating that P = S P*, while relative PPP emphasizes changes over time, expressed as dP/P = dS/S + dP*/P*. Signup and view all the answers

Explain how arbitrage mechanisms relate to the Purchasing Power Parity theory.

Arbitrage mechanisms exploit price discrepancies between countries, promoting equalization of prices in different currencies and enforcing PPP as traders buy low in one market and sell high in another. Signup and view all the answers

What impact do taxes have on pricing regarding the Purchasing Power Parity concept?

Taxes can distort the true price levels of goods, leading to deviations from PPP as they affect domestic prices and subsequently influence currency valuation. Signup and view all the answers

How does the Big Mac Index illustrate the principles of PPP?

The Big Mac Index compares the price of a Big Mac in different countries to evaluate whether currencies are undervalued or overvalued relative to the PPP theory. Signup and view all the answers

Study Notes

Purchasing Power Parity and Floating Exchange Rate Experience

Purchasing power parity (PPP) relates to exchange rates in the long run
Higher inflation in one country compared to another leads to depreciation of the first country's currency relative to the other
Short-run use of PPP for forecasting exchange rates is unreliable
Long-run use of PPP shows some usefulness

Motivation

Exchange rates impact Balance of Payments (BoP) and policy decisions
Understanding exchange rate determination is key
Chapters 6-8 focus on floating exchange rates

Theories of Exchange Rate Determination

Chapter 6: Exchange rates are determined by goods markets; Purchasing Power Parity (PPP) is a primary theory. Empirical testing of PPP shows it's an incomplete explanation of exchange rate movements.
Chapter 7: Incorporates money markets and bond markets into monetary models. It assumes domestic and foreign bonds are perfect substitutes. Empirical evidence suggests that, sometimes, the substitution assumption is wrong.
Chapter 8: Acknowledges imperfect substitutability of domestic and foreign bonds (risk premium for example) in exchange rate determination.

Idea Behind PPP: Law of One Price

The Law of One Price (LOP) suggests international arbitrage equalizes goods prices
To compare prices internationally, convert foreign prices to domestic currency using an exchange rate (S).
For good 'g': Pg = S • Pg*. (where Pg is the domestic price and Pg* is the foreign price)

Law of One Price (LOP)

Arbitrage equalizes prices internationally
Exchange rate converts foreign prices into domestic currency
In equilibrium: Pg = S•Pg*; if not, demand for the cheaper good increases, prompting adjustments in the exchange rate (S) until equilibrium is restored.

Example: Big Mac Parity

The Economist collects Big Mac prices globally.
Big Mac exchange rates are calculated by equalizing the Big Mac prices
SBM = PBM/P*BM
Helpful for evaluating currency undervaluation
Example: July 2023 data show euro is undervalued relative to the $

Big Mac Parity 1999-2011

Graph displays euro/dollar exchange rate and Big Mac rate over 1999-2011
Actual dollar price often lower than the Big Mac price, indicating euro overvaluation.

Using Big Macs for Exchange Rate

Big Mac prices aren't perfectly equalized due to taxes, price discrimination, transportation costs, which limit arbitrage.
The Big Mac price data offer a reasonable, but not perfect, way to gauge the relationship between the exchange rate and prices.

Comparing Big Mac to iPod

iPod exchange rate provides more arbitrage relative to exchange rate when compared to Big Mac rates.
Euro is overvalued based on iPod rates, consistent with the Big Mac example.

PPP and its Variants

PPP theory defines exchange rate as ratio of home and foreign price levels
(P/P*) = S; exchange rates reflect relative price levels

From LOP to PPP

If the Law of One Price (LOP) holds for all goods (Pg = S•Pg*), then so does Aggregate PPP, where aggregate prices are P and P*.
Purchasing Power Parity (PPP) arises and the currencies' purchasing power is identical across countries.

Absolute and Relative PPP

Absolute PPP (P= SP*) is impractical to verify directly as price levels are not typically published
Relative PPP (dP/P = dS/S + dP*/P*), only considers changes in price levels over time
Useful for comparing inflation to exchange rate movements over time

PPP in Reality

Relative PPP shows some evidence of usefulness when looking at long-term trends.
Data shows CPIs don't perfectly match (similar, but aren't quite equal).

Explaining Deviations from PPP

Trade costs and impediments: Limit arbitrage and thus deviations from PPP.
Tradables vs. non-tradables: Non-tradable goods and services often drive price differences.
Productivity differentials (Balassa-Samuelson effect): Richer countries' higher productivity leads to higher prices for non-traded goods
Higher wages in richer countries reflect greater productivity in traded goods sectors, which in turn leads to greater consumer prices across the economy
This effect creates price levels that violate the PPP equivalence relation.

Conclusion

PPP is a valuable model for short-run exchange rate determination
PPP is more relevant in long-run economic studies
PPP helps to understand the relation between inflation and currency value.

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Description

Explore the intricacies of exchange rate determination through Purchasing Power Parity and monetary models in this quiz based on Chapters 6 to 8. Understand how inflation impacts currency value and the relevance of exchange rates to Balance of Payments. Test your knowledge on these critical economic theories.