Chapter 2
Chapter 2
The law of one price state that in the presence of a competitive market
structure & the absence of transport costs & other barriers to trade,
identical products which are sold in different markets will be sold at
the same price when expressed in terms of a common currency
The law of one price is based up on the idea of perfect goods arbitrage
Example, If a car costs birr 180,000 in Ethiopia 20,000 in US & the
identical model, then according to the law of one price the exchange rate
should be 180,000/ 20,000, which is birr 9/USD
Suppose the actual exchange rate were higher than this at birr 9.20
/USD, then it would pay US citizens to buy a car in Ethiopia, because
with 19565 USD he can buy a car (180, 000/9.20) by doing so he will
save 435 USD compared to purchasing the car in the US market
According to the law of one price, US residents will exploit this
arbitrage possibility and start purchasing birr and selling dollars.
Such a process will continue until the birr appreciates to birr 9/USD at
which point arbitrage profit opportunities are eliminated
The proponents of PPP argue that the exchange rate must adjust to
ensure that the law of one price which applies, to individual good, also
holds internationally for identical bundles of goods
Purchasing power parity (PPP) theory comes in two forms on the basis
of strict interpretation of the law of one price
Absolute purchasing parity
Relative purchasing power parity
ABSOLUTE PURCHASING POWER PARITY (PPP)
…if one takes a bundle of goods in one country & compares the price of that
bundle with an identical bundle of goods sold in a foreign country converted by
the exchange into a common currency measurement, then the price will be equal
…if a bundle of goods costs birr 20 in 2 in the US, then the exchange
rate/Ethiopian & the same bundle costs defined as birr per dollar will be 20 birr/2
USD = birr 10/USD
Algebraically, the absolute version of PPP can expressed as S= p/*p
Where,
• S represents the exchange rate defined by domestic currency units (birr) per
unit of foreign Currency (USD)
• P – is the price of bundles of goods expressed in the domestic currency (price
in birr)
• P*- is the price of identical bundle of goods expressed in the foreign currency
(USD)
According to the absolute PPP a rise in the home price level relative to the
foreign price level will lead to a proportional depreciation of the home currency
against the foreign currency
RELATIVE PURCHASING POWER PARITY (PPP)
The absolute version of PPP is unlikely to hold precisely because of the
existence of transportation cost, imperfect information & the distorting
effect of tariffs & other forms of protectionism
…the relative version of the theory of PPP argues that the exchange rate will
adjust by the amount of the inflation differentials between two economies
This can be expressed as follows
%ΔS=% Δp−Δ*p
Where,
%Δs− the percentage change in the exchange rate
% Δp−The percentage change in the domestic inflation rates
% ΔP* the percentage change in the foreign inflation rate
According to the relative version of PPP, if the inflation rate in the US is 10
percent that of Ethiopia is 5 percent, the birr per dollar exchange rate should be
expected to appreciate by the approximately 5 percent
GENERALIZED VERSION OF PPP
One of the major problems with PPP is that it is supposed to hold for all
types of goods
However, a more generalized version of PPP provides some useful
insights & makes distinction among goods traded
According to general version of PPP goods can be categorized into
traded goods & non-traded goods
•Traded goods: - These are goods which are susceptible to
international competition
Automobile, Electronics products & fuels & the like
•Non traded goods: - are those that cannot be traded internationally at
a profit. Their price will not be affected by the international competition
Hair cut (hair dressing),Restaurant food services, Houses, etc
The distinction between them is due to the fact that the price of traded
goods will tend to be kept in line with the international competition,
…while the price of non-traded goods will be determined predominantly
by domestic supply & demand considerations
MEASUREMENT PROBLEMS & POOR PERFORMANCE OF THE
THEORY OF PPP
Many of the proponents of PPP argued prior the adoption of floating
exchange rate changes would be in line with those predicted by the
theory of PPP
One of such problems is that, whether the theory is applicable to both
traded & non-traded goods
PPP performs better for countries that are geographically close to one
another & where trade linkages are high
Exchange rates have been much volatile than the corresponding
national prices level
PPP holds better in the long-run than in the short-run
The currencies of countries with very high inflation rates relative to their
trading partners, mostly likely would experience depreciation reflecting
their high inflation rate->
…PPP is the dominant force in determining their exchange rate
Alternatively:
Md/P = L(R,Y)
Aggregate demand of real monetary assets is a function of national
income and interest rates.
Fig. 15-1: Aggregate Real Money
Demand and the Interest Rate
Fig. 15-2: Effect on the Aggregate Real Money Demand
Schedule of a Rise in Real Income
A Model of the Money Market
• The money market is where monetary or liquid assets,
which are loosely called “money,” are lent and borrowed.
• Monetary assets in the money market generally have low interest
rates compared to interest rates on bonds, loans, and deposits of
currency in the foreign exchange markets.
• Domestic interest rates directly affect rates of return on domestic
currency deposits in the foreign exchange markets.
A Model of the Money Market
(cont.)
• When no shortages (excess demand) or surpluses
(excess supply) of monetary assets exist, the model
achieves an equilibrium:
Ms = M d
• Alternatively, when the quantity of real monetary assets
supplied matches the quantity of real monetary assets
demanded, the model achieves an equilibrium:
Ms/P = L(R,Y)
A Model of the Money Market
(cont.)
• When there is an excess supply of monetary assets, there
is an excess demand for interest- bearing assets like
bonds, loans, and deposits.
• People with an excess supply of monetary assets are willing to
offer or accept interest-bearing assets (by giving up their money) at
lower interest rates.
• Others are more willing to hold additional monetary assets as
interest rates (the opportunity cost of holding monetary assets) fall.
A Model of the Money Market
(cont.)
• When there is an excess demand of monetary assets,
there is an excess supply of interest- bearing assets
like bonds, loans, and deposits.
• People who desire monetary assets but do not have access to
them are willing to sell nonmonetary assets in return for the
monetary assets that they desire.
• Those with monetary assets are more willing to give them up in
return for interest-bearing assets as interest rates (the
opportunity cost of holding money) rise.
Fig. 15-3: Determination of the Equilibrium Interest
Rate
Fig. 15-4: Effect of an Increase in the Money
Supply on the Interest Rate
Fig. 15-5: Effect on the Interest
Rate of a Rise in Real Income
Fig. 15-6:
Simultaneous
Equilibrium in the U.S.
Money Market and the
Foreign Exchange
Market
Fig. 15-7: Money Market/Exchange Rate Linkages
Fig. 15-8: Effect on the
Dollar/Euro Exchange
Rate and Dollar Interest
Rate of an Increase in the
U.S. Money Supply
Changes in the Domestic Money Supply
2. Inflationary expectations:
• If workers expect future prices to rise due to an expected money supply
increase, they will want to be compensated.
• And if producers expect the same, they are more willing to raise wages.
• Producers will be able to match higher costs if they expect to raise
prices.
• Result: expectations about inflation caused by an expected increase in
the money supply causes actual inflation.
Money, Prices, Exchange Rates, and Expectations
Md* = k*P*y*
Ms/Ms*=kPy/k*P*y*
Since P /P* = S because of PPP,
Ms/Ms*=kSy/k*y*
& solving the above equation for Exchange Rate:
S=Ms/Ms*
Ky/k *y*