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Chapter 2

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0% found this document useful (0 votes)
23 views47 pages

Chapter 2

Uploaded by

chernetgirma11
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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THE LAW OF ONE PRICE

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

At the beginning PPP seems readily applicable to traded goods.


However, some people argued that the distinction between tradable &
non-tradable is fuzzy, because in most cases they are linked to each
other. Moreover tradable goods are used as input into the production of
non-tradable goods
s

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

PPP holds better for traded goods than non-traded goods


The price of non-traded goods tends to be more expensive in rich
countries than in poor countries once they are converted into a common
currency
Money, Interest Rates, and
Exchange Rates
• What is money?
• Control of the supply of money
• The willingness to hold monetary assets
• A model of real monetary assets and
interest rates
• A model of real monetary assets, interest rates, and exchange rates
• Long-run effects of changes in money on prices, interest rates, and
exchange rates
• The monetary model of exchange rate determination
What Is Money?
• Money is an asset that is widely used as a means of
payment.
• Different groups of assets may be classified as money.
• Money can be defined narrowly or broadly.

• Currency in circulation, checking deposits, and debit card accounts form


a narrow definition of money.
• Deposits of currency are excluded from this narrow definition, although
they may act as a substitute for money in a broader definition.
What Is Money? (cont.)
• Money is a liquid asset: it can be easily used to pay for
goods and services or to repay debt without substantial
transaction costs.
• But monetary or liquid assets earn little or no interest.
• Illiquid assets require substantial transaction costs in
terms of time, effort, or fees to convert them to funds for
payment.
• But they generally earn a higher interest rate or rate of return than
monetary assets.
What Is Money? (cont.)
• Let’s group assets into monetary assets (or liquid assets)
and nonmonetary assets (or illiquid assets).
• The demarcation between the two is arbitrary,
• but currency in circulation, checking deposits, debit card accounts,
savings deposits, and time deposits are generally more liquid than
bonds, loans, deposits of currency in the foreign exchange
markets, stocks, real estate, and other assets.
Money Supply
• The central bank substantially controls the quantity of
money that circulates in an economy, the money supply.
• In the U.S., the central banking system is the Federal Reserve
System.
• The Federal Reserve System directly regulates the amount of currency
in circulation.
• It indirectly influences the amount of checking deposits, debit card
accounts, and other monetary assets.
Money Demand
• Money demand represents the amount of monetary
assets that people are willing to hold (instead of illiquid
assets).
• What influences willingness to hold monetary assets?

• We consider individual demand of money and aggregate demand


of money.
What Influences Demand of Money for Individuals
and Institutions?
1. Interest rates/expected rates of return on monetary assets
relative to the expected rates of returns on non-monetary assets.
2. Risk: the risk of holding monetary assets principally comes from
unexpected inflation, which reduces the purchasing power of
money.
• But many other assets have this risk too, so this risk is not very
important in defining the demand of monetary assets versus
nonmonetary assets.

3. Liquidity: A need for greater liquidity occurs when the price of


transactions increases or the quantity of goods bought in
transactions increases.
What Influences Aggregate
Demand of Money?
1. Interest rates/expected rates of return: monetary assets pay
little or no interest, so the interest rate on non-monetary assets like
bonds, loans, and deposits is the opportunity cost of holding
monetary assets.
• A higher interest rate means a higher opportunity cost of holding
monetary assets  lower demand of money.
2. Prices: the prices of goods and services bought in transactions will
influence the willingness to hold money to conduct those
transactions.
• A higher level of average prices means a greater need for liquidity to
buy the same amount of goods and services  higher demand of
money.
What Influences Aggregate
Demand of Money? (cont.)
3. Income: greater income implies more goods and services can be
bought, so that more money is needed to conduct transactions.
• A higher real national income (GNP) means more goods and services
are being produced and bought in transactions, increasing the need
for liquidity  higher demand of money.
A Model of Aggregate Money Demand

The aggregate demand of money can be expressed as:


Md = P x L(R,Y)
where:
P is the price level
Y is real national income
R is a measure of interest rates on nonmonetary assets
L(R,Y) is the aggregate demand of real monetary assets

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

• An increase in a country’s money supply causes interest


rates to fall, rates of return on domestic currency deposits
to fall, and the domestic currency to depreciate.
• A decrease in a country’s money supply causes interest
rates to rise, rates of return on domestic currency
deposits to rise, and the domestic currency to appreciate.
Changes in the Foreign Money Supply

• How would a change in the supply of euros affect the


U.S. money market and foreign exchange markets?
• An increase in the supply of euros causes a depreciation
of the euro (an appreciation of
the dollar).
• A decrease in the supply of euros causes an appreciation
of the euro (a depreciation of the dollar).
Changes in the Foreign Money Supply (cont.)

• The increase in the supply of euros reduces interest rates


in the EU, reducing the expected rate of return on euro
deposits.
• This reduction in the expected rate of return on euro
deposits causes the euro to depreciate.
• We predict no change in the U.S. money market due to
the change in the supply of euros.
Long Run and Short Run
• In the short run, prices do not have sufficient time to adjust
to market conditions.
• The analysis heretofore has been a short-run analysis.

• In the long run, prices of factors of production and of output


have sufficient time to adjust to market conditions.
• Wages adjust to the demand and supply of labor.
• Real output and income are determined by the amount of workers and
other factors of production—by the economy’s productive capacity—
not by the quantity of money supplied.
• (Real) interest rates depend on the supply of saved funds and the
demand of saved funds.
Long Run and Short Run (cont.)
• In the long run, the quantity of money supplied is
predicted not to influence the amount of output, (real)
interest rates, and the aggregate demand of real
monetary assets L(R,Y).
• However, the quantity of money supplied is predicted to
make the level of average prices adjust proportionally in
the long run.
• The equilibrium condition Ms/P = L(R,Y) shows that P is predicted
to adjust proportionally when Ms adjusts, because L(R,Y) does not
change.
Long Run and Short Run (cont.)
• In the long run, there is a direct relationship between the
inflation rate and changes in the money supply.
Ms = P x L(R,Y)
P = Ms/L(R,Y)
P/P = Ms/Ms – L/L
• The inflation rate is predicted to equal the growth rate in money
supply minus the growth rate in money demand.
Money and Prices in the Long Run
• How does a change in the money supply cause prices
of output and inputs to change?
1. Excess demand of goods and services: a higher quantity of
money supplied implies that people have more funds available to
pay for goods and services.
• To meet high demand, producers hire more workers, creating a strong
demand of labor services, or make existing employees work harder.
• Wages rise to attract more workers or to compensate workers for
overtime.
• Prices of output will eventually rise to compensate for higher costs.
Money and Prices in the Long Run (cont.)
• Alternatively, for a fixed amount of output and inputs, producers can
charge higher prices and still sell all of their output due to the high
demand.

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

• When we consider price changes in the long run,


inflationary expectations will have an effect in foreign
exchange markets.
• Suppose that expectations about inflation change as
people change their minds, but actual adjustment of
prices occurs afterwards.
Fig. 15-12: Short-Run and Long-Run Effects of an Increase
in the U.S. Money Supply (Given Real Output, Y)
Money, Prices, and Exchange Rates in the Long
Run
• A permanent increase in a country’s money supply
causes a proportional long-run depreciation of its
currency.
• However, the dynamics of the model predict a large depreciation
first and a smaller subsequent appreciation.

• A permanent decrease in a country’s money supply


causes a proportional long-run appreciation of its
currency.
• However, the dynamics of the model predict a large appreciation
first and a smaller subsequent depreciation.
Fig. 15-13: Time Paths of U.S. Economic Variables
after a Permanent Increase in the U.S. Money
Supply
Exchange Rate Overshooting
• The exchange rate is said to overshoot when its
immediate response to a change is greater than its long-
run response.
• Overshooting is predicted to occur when monetary policy
has an immediate effect on interest rates, but not on prices
and (expected) inflation.
• Overshooting helps explain why exchange rates are so
volatile.
A Monetary Exchange-Rate Equation
Before measuring the effect of various shocks under
fixed & floating exchange rates, let us see how exchange
rate determined

dd for money in the home country:


Md = kPy
dd for money in the foreign economy:

Md* = k*P*y*

Where Md* the foreign money dd


k* the foreign nominal income elasticity of dd for
money
P* the foreign price level
y* real foreign income
Exchange rate is determined by PPP
S = P/P*In equilibrium money dd is equal to SS in each
country,
Ms = Md & Ms* = Md*

Relative money SS functions , 8 replacing Md & Md* with


Ms & Ms*:

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*

…..the exchange rate is determined by the


relative SS & dd for the different national
money stocks
• An increase in the domestic money stock relative to
foreign money stock lead….
…to a depreciation (rise) of the home currency

• An increase in domestic income relative to foreign


income lead…
… to an appreciation (fall) in the exchange rate

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