1.

Law of one price

2. Purchasing power parity

3. Relationship between interest rates and

inflation: Fisher effect
4. Real exchange rate
The Behavior of Exchange Rates

What models can predict how exchange rates behave?

• In last chapter we studied a short-run model that used the difference
between currencies’ interest rates.
• In this chapter, we study a long-run model that used the difference
between currencies’ inflation rates.
• 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.
1. The law of The law of one price simply says that the same good in
one price 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
USD, while the price of the same pizza at an identical
restaurant across the street is 40 USD.

What do you predict will happen? Many people will buy

the 20 pizza USD, few will buy the 40 USD one.
1. The law of Due to the price difference, entrepreneurs would have an
incentive to buy pizza at the cheap location and sell it at
one price the expensive location for an easy profit.
Due to strong demand and decreased supply, the price of
the 20 USD pizza would tend to increase.

Due to weak demand and increased supply, the price of

the 40 USD 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).
1. The law of Consider a pizza restaurant in Seattle and one across the
border in Vancouver.
one price
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.

Pi
E =
Pi *
 2. The purchasing power parity

• Domestic (internal) purchasing power: is the amount of goods and services that
can be purchased with one unit of currency in the domestic market.
➢ Domestic purchasing power & inflation rate? ➔ 1/P
• International (external) purchasing power: is the amount of goods and services
that can be purchased with one unit of currency in the foreign market.
➢ International purchasing power & E, foreign country inflation rate? ➔ 1/(E.P*)
 • Purchasing power parity is the application of the law
of one price across countries for all goods and services,
2. The or for representative groups (“baskets”) of goods and
services.
Purchasing
Power Parity • Purchasing power parity (PPP) implies that the
exchange rate is determined by levels of average prices
𝑃
𝐸𝑃 = ∗
𝑃
 3.99 USD 89,000 VND

The percentage of real overvaluation/real undervaluation of a currency (1)

𝐸 − 𝐸𝑝 𝐸𝑝 − 𝐸
𝑣𝑟𝐶 = 𝑣𝑟𝑇 =
𝐸𝑝 𝐸
 2. The purchasing power parity

The Assumptions of PPP

1. No international transportation costs
2. No trade barriers
3. No risk in the international commodities trading
4. All commodities have the same quality (perfectly substitution)
5. A perfectly competitive international commodities market
 2. The purchasing power parity

Forming mechanism: arbitrage in the international commodity market

12
2. The purchasing power parity

Assuming of a difference: E.P* > P

➔ arbitrage occurs in the following steps:
Step 1: Use domestic currency to buy domestic goods
Step 2: Sell goods abroad to get foreign currency
Step 3: Convert foreign currency into domestic currency
(sell foreign currency buy domestic currency)

∗ 𝑃
Arbitrage 𝐸. 𝑃 = 𝑃 ⇒ 𝐸 = = 𝐸𝑃
𝑃∗

13
2. The purchasing power parity

If the price level in the U.S.

is 200 USD per basket, while
the price level in Canada is
320 CAD per basket, PPP
implies that the USD/CAD
exchange rate should be
320/200 = 1.6
2. The purchasing power parity

Purchasing power parity (PPP) comes in 3 forms:

❖ Absolute PPP: purchasing power parity that has already been discussed.
Exchange rates equal the level of relative average prices across countries:
𝑃
𝐸= ∗
𝑃
❖ Relative PPP: changes in exchange rates equal changes in prices (inflation)
between two periods.
❖ Expected PPP: changes in expected exchange rates equal changes in expected
prices (inflation) between two periods.
2. The purchasing power parity
Different forms of the PPP
Length of
The absolute form The relative form
the period

CPI1
1 year E1 = E0
CPI1*

< 1 year

> 1 year
 Approximate form Expected form

Meaning of PPP
• PPP is the basis for forming the exchange rate.
• Because movements in the international commodity markets happen in the long-run,
PPP helps to explain and predict the long-run exchange rate movements.
• Based on the inflation rate differential between the two currencies, the currency with
the higher inflation rate is expected to depreciate, and the currency with a lower
inflation rate is expected to appreciate.
• The inflation rate differential between two countries is equal to the expected changes
between the exchange rates of two countries.
(!) Shortcomings of PPP

• There is little empirical support for absolute

purchasing power parity:
The prices of identical commodity baskets, when
converted to a single currency, differ substantially
across countries.
• Relative PPP is more consistent with data, but it
also performs poorly to predict exchange rates.
The Yen/Dollar Exchange Rate and Relative Japan - U.S. Price Levels, 1980 - 2012
 Reasons why PPP may not be accurate: the law of
one price may not hold because of
Shortcomings (1) Trade barriers and nontradable products
of PPP (2) Imperfect competition
(3) Differences in measures of average prices for
baskets of goods and services
Shortcomings of PPP

(1) Trade barriers and nontradable products

• Transport costs and governmental trade restrictions make trade expensive
and in some cases create nontradable goods or services.
• Services are often not tradable: services are generally offered within a
limited geographic region (for example, haircuts).
• The greater the transport costs, the greater the range over which the
exchange rate can deviate from its PPP value.
• One price need not hold in two markets.
Shortcomings of PPP

(2) Imperfect competition may result in price discrimination: “pricing to

market.”
• A firm sells the same product for different prices in different markets to
maximize profits, based on expectations about what consumers are willing
to pay.
• One price need not hold in two markets.
Shortcomings of PPP

(3) Differences in the measure of average prices for goods and services
• levels of average prices differ across countries because of differences in
how representative groups (“baskets”) of goods and services are measured.
• Because measures of groups of goods and services are different, the
measure of their average prices need not be the same.
• One price need not hold in two markets.
 3. The Fisher Effect
• The Fisher effect (named affect Irving Fisher) describes the relationship between
nominal interest rates and inflation.

• The interest parity condition:

Δ𝑒 𝑒 = 𝑟 − 𝑟 ∗

• If financial markets expect (relative) PPP to hold, then expected exchange rate
changes will equal expected inflation between countries:

Δ𝑒 𝑒 = 𝜋 𝑒 − 𝜋 𝑒∗

If both IRP & PPP hold 𝑟 − 𝑟 ∗ = 𝜋 𝑒 − 𝜋 𝑒∗ → 𝑟𝑟𝑒 = 𝑟𝑟𝑒∗

3. The International Fisher Effect (IFE)

“The Fisher condition in the open

economy” or “The International Fisher
Effect” states that the real exchange
rates of currencies are always expected
to be the same.

𝑟𝑟𝑒 = 𝑟𝑟𝑒∗

25
 The IFE’s implications:
Exchange rate ➢ Investors, who are trying to invest in a country
with high interest rates, may be adversely
affected by the impact of high inflation in that
country.
➢ The currencies with higher expected interest
rates will also have higher expected inflations,
therefore they are expected to depreciate.
Inflation rate IFE Interest rate Investors do not necessarily invest in
profitable securities in countries with higher
interest rates because the impact of the
exchange rate can offset the interest rate
advantage in every phase.
 4. Real
exchange rate

4.1 Bilateral Nominal Exchange Rate – NER

4.2 Bilateral Real Exchange Rate – RER
4.3 Nominal Effective Exchange Rate – NEER
4.4 Real Effective Exchange Rate - REER
Direct quote is used Domestic currency Foreign currency is
for all exchange rates is term currency (T) commodity currency (C)

E.g: USD/VND
 The concept of
International trade competitiveness
“International trade competitiveness” is related to all
relevant factors influencing exports and imports of
goods and services of one country. However, when
focusing on the exchange rate factor, international trade
competitiveness is understood more narrowly and
specifically
➢ Absolute form
➢ Relative form
➢ Absolute form
❑ Exports > Imports (with a particular partner) ➔ the country has higher
international trade competitiveness position.
❑ Exports < Imports (with a particular partner) ➔ the country has lower
international trade competitiveness position.
➢ Relative form
❑ Growth of Exports > of Imports (with a particular partner) ➔ international trade
competitiveness of the country is improved.
❑ Growth of Exports < of Imports (with a particular partner) ➔ international trade
competitiveness of the country is eroded.
 4.1. Bilateral Nominal Exchange Rate – NER

NER is the price of a currency in terms of another without concerning their

purchasing power
Exchange rate Index Et
e 0
t =
E0

et0  100 % Exchange rate increase

( Et  E 0 ) Foreign currency appreciates, Domestic currency depreciates

et0  100 % Exchange rate decrease

( Et  E 0 ) Foreign currency depreciates, Domestic currency appreciates
4.1. Bilateral Nominal Exchange Rate – NER
The percentage change (%) of a currency

%(C) > 0 • (C) appreciates

%(C) < 0 • (C) depreciates

 4.2. Bilateral Real Exchange Rate – RER

RER is nominal exchange rate adjusted by domestic and foreign inflation rates;
therefore, it is the index which reflects the correlation of purchasing power between
domestic currency and foreign currency
Absolute form of RER
P * E.P *
er = E x =
P P
Relative form of RER
0*
e CPI
ert =
0 rt
= et x
0 t
0
x100 %
er 0 CPIt
er = 1 • The price of a basket of goods would be the same in 2 countries
( E.P* = P ) ➢ 2 currencies are at purchasing power parity (PPP)
 • The level price in home country is lower than in the foreign country.
➢ International trade competitiveness of home country is higher than
of the foreign country.
er  1
( E.P*  P ) • With each unit of domestic currency, we can buy fewer goods in the
foreign country compared to home country.
➢ Domestic currency is real undervalued
➢ Foreign currency is real overvalued.

The currency which is real undervalued will strengthen international

trade competitiveness of its country in comparison with that of foreign
country by encouraging exports and penalizing imports
 • The level price in home country is higher than in the foreign country
➢ International trade competitiveness of home country is lower than of
the foreign country.
er  1
• With each unit of domestic currency, we can buy more goods in the
( E.P*  P )
foreign country compared to home country.
➢ Domestic currency is real overvalued
➢ Foreign currency is real undervalued.

The currency which is real overvalued will lower international trade

competitiveness of its country in comparison with that of foreign country
by encouraging imports and penalizing exports
The percentage of real overvalued/real undervalued of a currency (2)

>0 • (C) is real overvalued

<0 • (C) is real undervalued

 0*
e CPI
ert0 = rt = et0 x t
0
x100 %
er 0 CPIt

• Real exchange rate unchanged

e = 100%
0
rt ➢ Maintain international trade competitiveness.
 • Real exchange rate increases
➢ Relative purchasing power of domestic currency decreases
e  100%
0
rt
➢ Domestic currency real depreciates, foreign currency real appreciates
➢ Improve international trade competitiveness

The real depreciated currency could improve international trade

competitiveness of its country.
 • Real exchange rate decreases
➢ Relative purchasing power of domestic currency increases
e  100%
0
rt
➢ Domestic currency real appreciates, foreign currency real depreciates
➢ Erode international trade competitiveness

The real appreciated currency could erode international trade

competitiveness of its country.
The percentage of real appreciated/real depreciated of a currency

%(C) > 0 • (C) real appreciates

%(C) < 0 • (C) real depreciates

4. Real exchange rate