ECO2008 International Economics Past Paper PDF 2024-2025

ECO2008 International Economics Price Levels and the Exchange Rate in the Long Run Week 13a Brian Varian The Behavior of Exchange Rates What models can predict how exchange rates behave? – Last week, we developed a short-run model and a...

ECO2008 International Economics Price Levels and the Exchange Rate in the Long Run Week 13a Brian Varian The Behavior of Exchange Rates What models can predict how exchange rates behave? – Last week, we developed a short-run model and a long-run model that used movements in the money supply. – This week, we develop 2 more models, building on the long-run approach from last chapter. – Long run means a 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. – Because prices are allowed to change, they will influence interest rates and exchange rates in the long-run models. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Law of One Price (1 of 3) The law of one price simply says that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important. – Why? Suppose the price of pizza at one restaurant is $20, while the price of the same pizza at an identical restaurant across the street is $40. – What do you predict will happen? Many people will buy the $20 pizza, few will buy the $40 one. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Law of One Price (2 of 3) – Due to the price difference, entrepreneurs would have an incentive to buy pizza at the cheap location and sell it at the expensive location for an easy profit. – Due to strong demand and decreased supply, the price of the $20 pizza would tend to increase. – Due to weak demand and increased supply, the price of the $40 pizza would tend to decrease. – People would have an incentive to adjust their behavior and prices would tend to adjust until one price is achieved across markets (across restaurants). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Law of One Price (3 of 3) Consider a pizza restaurant in Seattle and one across the border in Vancouver. The law of one price says that the price of the same pizza (using a common currency to measure the price) in the two cities must be the same if markets are competitive and transportation costs and barriers between markets are not important. P pizzaUS = EUS$/C$ × P pizza Canada  P pizzaUS = priceof pizzainSeattle P pizza Canada = priceof pizzain Vancouver EUS$/C$ = U.S.dollar/Canadiandollar exchangerate Copyright © 2018 Pearson Education, Ltd. All rights reserved.  Purchasing Power Parity (1 of 3) Purchasing power parity is the application of the law of one price across countries for all goods and services, or for representative groups (“baskets”) of goods and services. PUS = EUS$/C$ × PCanada  PUS = level of average prices in the U.S. PCanada = level of average prices in Canada EUS$/C$ = U.S.doller/Canadian doller exchange rate Copyright © 2018 Pearson Education, Ltd. All rights reserved. Purchasing Power Parity (2 of 3) Purchasing power parity (PPP) implies that the exchange rate is determined by levels of average prices PUS E US$  C$ PCanada – If the price level in the U.S. is US$200 per basket, while the price level in Canada is C$400 per basket, PPP implies that the C$/US$ exchange rate should be C$400/US$200 = C$2/US$1. – Predicts that people in all countries have the same purchasing power with their currencies: 2 Canadian dollars buy the same amount of goods as 1 U.S. dollar, since prices Copyright in Canada © 2018 Pearson are Education, Ltd. All rightstwice reserved. Purchasing Power Parity (3 of 3) Purchasing power parity (PPP) comes in 2 forms: Absolute PPP: purchasing power parity that has already been discussed. Exchange rates equal the level of relative average prices across countries. PUS E$ / €  PEU Relative PPP: changes in exchange rates equal changes in prices (inflation) between two periods: (E$ / €,t  E$ / €, t  1 )  US,t   EU,t E$ / €, t  1 wher  t  inflation rate from perid t  1 to t e Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monetary Approach to Exchange Rates (1 of 5) Monetary approach to the exchange rate: uses monetary factors to predict how exchange rates adjust in the long run, based on the absolute version of PPP. – It predicts that levels of average prices across countries adjust so that the quantity of real monetary assets supplied will equal the quantity of real monetary assets M Sdemanded: PUS  US L R$ ,YUS  M S EU PEU  L R€ ,YEU  Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monetary Approach to Exchange Rates (2 of 5) To the degree that PPP holds and to the degree that prices adjust to equate the quantity of real monetary assets supplied with the quantity of real monetary assets demanded, we have the following prediction: – The exchange rate is determined in the long run by prices, which are determined by the relative supply and demand of real monetary assets in money markets across countries. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monetary Approach to Exchange Rates (3 of 5) Predictions about changes in 1. Money supply: a permanent rise in the domestic money supply – causes a proportional increase in the domestic price level, – thus causing a proportional depreciation in the domestic currency (through PPP). – This is same prediction as long-run model without PPP. 2. Interest rates: a rise in domestic interest rates – lowers the demand of real monetary assets, – and is associated with a rise in domestic prices, – thus causing a proportional depreciation of the domestic currency (through PPP). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monetary Approach to Exchange Rates (4 of 5) 3. Output level: a rise in the domestic level of production and income (output) – raises domestic demand of real monetary assets, – and is associated with a decreasing level of average domestic prices (for a fixed quantity of money supplied), – thus causing a proportional appreciation of the domestic currency (through PPP). All 3 changes affect money supply or money demand, and cause prices to adjust so that the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, and cause exchange rates to adjust according to PPP. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monetary Approach to Exchange Rates (5 of 5) A change in the money supply results in a change in the level of average prices. A change in the growth rate of the money supply results in a change in the growth rate of prices (inflation). – A constant growth rate in the money supply results in a persistent growth rate in prices (persistent inflation) at the same constant rate, when other factors are constant. – Inflation does not affect the productive capacity of the economy and real income from production in the long run. – Inflation, however, does affect nominal interest rates. How? Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Fisher Effect (1 of 2) The Fisher effect (named after Irving Fisher) describes the relationship between nominal interest rates and inflation. – Derive the Fisher effect from the interest parity condition: R$  R€  E  e $ / €  E$ / €  E$ / € – If financial markets expect (relative) PPP to hold, then expected exchange rate changes will equal expected inflation between countries: R$  R€   E e $ / €  E$ / €   e   eEU US E$ / € Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Fisher Effect (2 of 2) – Therefor R$  R€  eUS   eEU e, – 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monetary Approach to Exchange Rates (1 of 2) Suppose that the U.S. central bank unexpectedly increases the growth rate of the money supply at time t0.  in the US before an    Suppose after also this that thetime, but that inflation tis0 European rate the d rate remains at inflation 0%. According to the Fisher effect, the interest rate in the U.S. will adjust to the higher inflation rate. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 16.1 Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money Supply Copyright © 2018 Pearson Education, Ltd. All rights reserved. Monetary Approach to Exchange Rates (2 of 2) The increase in nominal interest rates decreases the demand of real monetary assets. In order for the money market to maintain equilibrium in the long run, prices must jump so that M S US PUS  L R$ ,YUS  In order to maintain PPP, the exchange rate must jump (the dollar must depreciate) so that PUS E$ / €  PEU Thereafter, the money supply and prices are predicted togrow   atand rate the domestic currency is predicted to depreciate at the same rate. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Role of Inflation and Expectations (1 of 3) In the long-run model without PPP: Changes in money supply lead to changes in the level of average prices. No inflation is predicted to occur in the long run, but only during the transition to the long-run equilibrium. During the transition, inflation causes the nominal interest rate to increase to its long-run value. Expectations of higher domestic inflation cause the expected return on foreign currency deposits to increase, making the domestic currency depreciate before the transition period. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Role of Inflation and Expectations (2 of 3) In the monetary approach (with PPP), the rate of inflation increases permanently when the growth rate of the money supply increases permanently. With persistent domestic inflation (above foreign inflation), the monetary approach also predicts an increase in the domestic nominal interest rate. Expectations of higher domestic inflation cause the expected purchasing power of domestic currency to decrease relative to the expected purchasing power of foreign currency, thereby making the domestic currency depreciate. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Role of Inflation and Expectations (3 of 3) In the long-run model without PPP, the level of average prices does not immediately adjust even if expectations of inflation adjust, – causing the exchange rate to overshoot (causing the domestic currency to depreciate more than) its long-run value. In the monetary approach (with PPP), the level of average prices adjusts with expectations of inflation, – causing the domestic currency to depreciate, but with no overshooting. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Real Exchange Rate Approach to Exchange Rates (1 of 10) Because of the shortcomings of PPP, economists have tried to generalize the monetary approach to PPP to make a better theory. The real exchange rate is the rate of exchange for goods and services across countries. – In other words, it is the relative value/price/cost of goods and services across countries. – For example, it is the dollar price of a European group of goods and services relative to the dollar price of an American group of goods and services: qUS  E $/ € PEU  EU PUS Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Real Exchange Rate Approach to Exchange Rates (2 of 10) qUS  E $/ € PEU  EU PUS – If the EU basket costs €100, the U.S. basket costs $120, and the nominal exchange rate is $1.20 per euro, then the real exchange rate is 1 U.S. basket per 1 EU basket. – A real depreciation of the value of U.S. products means a fall in a dollar′s purchasing power of EU products relative to a dollar′s purchasing power of U.S. products.  This implies that U.S. goods become less expensive and less valuable relative to EU goods.  This implies that Copyright the value of U.S. © 2018 Pearson goods Education, relative Ltd. All rights reserved. The Real Exchange Rate Approach to Exchange Rates (3 of 10) qUS  E $/ € PEU  EU PUS – A real appreciation of the value of U.S. products means a rise in a dollar’s purchasing power of EU products relative to a dollar’s purchasing power of U.S. products.  This implies that U.S. goods become more expensive and more valuable relative to EU goods.  This implies that the value of U.S. goods relative to valueCopyright of EU goods © 2018 rises.Ltd. All rights reserved. Pearson Education, The Real Exchange Rate Approach to Exchange Rates (4 of 10) According to PPP, exchange rates are determined by relative average prices: PUS E$ / €  PEU According to the more general real exchange rate approach, exchange rates may also be influenced by the real exchange rate: PUS E$ / €  qUS  EU PEU What influences the real exchange rate? Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Real Exchange Rate Approach to Exchange Rates (5 of 10) A change in relative demand of U.S. products – An increase in relative demand of U.S. products causes the value (price) of U.S. goods relative to the value (price) of foreign goods to rise. – A real appreciation of the value of U.S. goods: PUS rises relative to E$ / € PEU – The real appreciation of the value of U.S. goods makes U.S. exports more expensive and imports into the U.S. less expensive (thereby reducing the relative quantity demanded of U.S. products). – A decrease in relative demand of U.S. products causes a real depreciation of the value of U.S. goods. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Real Exchange Rate Approach to Exchange Rates (6 of 10) A change in relative supply of U.S. products – An increase in relative supply of U.S. products (caused by an increase in U.S. productivity) causes the price/cost of U.S. goods relative to the price/cost of foreign goods to fall. – A real depreciation of the value of U.S. goods: PUS falls relative to E$ / € PEU – The real depreciation of the value of U.S. goods makes U.S. exports less expensive and imports into the U.S. more expensive (thereby increasing relative quantity demanded to match increased relative quantity supplied). – A decrease in relative supply of U.S. products causes a real appreciation of the value of U.S. goods. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Real Exchange Rate Approach to Exchange Rates (7 of 10) The real exchange rate is a more general approach to explain exchange rates. Both monetary factors and real factors influence nominal exchange rates: 1a. Increases in monetary levels lead to temporary inflation and changes in expectations about inflation. 1b. Increases in monetary growth rates lead to persistent inflation and changes in expectations about inflation. 2a. Increases in relative demand of domestic products lead to a real appreciation. 2b. Increases in relative supply of domestic products lead to Copyright a real© 2018 depreciation. Pearson Education, Ltd. All rights reserved. The Real Exchange Rate Approach to Exchange Rates (8 of 10) What are the effects on the nominal exchange rate? P E$ / €  qUS  US EU PEU When only monetary factors change and PPP holds, we have the same predictions as before. – No changes in the real exchange rate occurs. When factors influencing real output change, the real exchange rate changes. – With an increase in relative demand of domestic products, the real exchange rate adjusts to determine nominal exchange rates. – With an increase in relative supply of domestic products, the situation is more complex. Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Real Exchange Rate Approach to Exchange Rates (9 of 10) With an increase in the relative supply of domestic products, the real exchange rate adjusts to make the price/cost of domestic goods depreciate, but the relative amount of domestic output also increases. – This second effect increases the demand of real monetary assets in the domestic economy: M SUS PUS  L R$ ,YUS  – Thus the level of average domestic prices is predicted to decrease relative to the level of average foreign prices. – The effect on the nominal PUS E$ / €  qUS exchange rate is ambiguous: EU PEU ?   Copyright © 2018 Pearson Education, Ltd. All rights reserved. The Real Exchange Rate Approach to Exchange Rates (10 of 10) When economic changes are influenced only by monetary factors, and when the assumptions of PPP hold, nominal exchange rates are determined by PPP. When economic changes are caused by factors that affect real output, exchange rates are not determined by PPP only, but are also influenced by the real exchange rate. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Table 16.1 Effects of Money Market and Output Market Changes on the Long-Run Nominal Dollar/Euro Exchange Rate, E$/€ Effect on the Long-Run Nominal Change Dollar/Euro Exchange Rate, E$/€ Money market Blank 1. Increase in U.S. money supply level Proportional increase (nominal depreciation of $) 2. Increase in European money supply level Proportional decrease (nominal depreciation of euro) 3. Increase in U.S. money supply growth rate Increase (nominal depreciation of $) 4. Increase in European money supply Decrease (nominal depreciation of growth rate euro) Output market Blank 1. Increase in demand for U.S. output Decrease (nominal appreciation of $) 2. Increase in demand for European output Increase (nominal appreciation of euro) 3. Output supply increase in the United Ambiguous States 4. Output supply increase in EuropeCopyright © 2018 Pearson Education, Ltd. All rights reserved. Ambiguous Summary (1 of 3) 1. The law of one price says that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between markets are not important. 2. Purchasing power parity applies the law of one price for all goods and services among all countries. – Absolute PPP says that currencies of two countries have the same purchasing power. – Relative PPP says that changes in the nominal exchange rate between two countries equals the difference in the inflation rates between the two countries.Copyright © 2018 Pearson Education, Ltd. All rights reserved. Summary (2 of 3) 3. The monetary approach to exchange rates uses PPP and the supply and demand of real monetary assets. – Changes in the growth rate of the money supply influence inflation and exchange rates. – Expectations about inflation influence the exchange rate. – The Fisher effect shows that differences in nominal interest rates are equal to differences in inflation rates. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Summary (3 of 3) 4. The real exchange rate approach to exchange rates generalizes the monetary approach. – It defines the real exchange rate as the value/price/cost of domestic products relative to foreign products. – It predicts that changes in relative demand and relative supply of products influence real and nominal exchange rates. Copyright © 2018 Pearson Education, Ltd. All rights reserved.