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
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. 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
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/broadly
•Narrow definition of money: currency in circulation, checking
deposits, and debit card accounts.
•Broader definition of money: deposits of currency are excluded
from this narrow definition, although they may act as a substitute for
money.
 What Is Money? (cont.)
• Money is a liquid asset: it can be easily used to
pay for goods & services

• But monetary or liquid assets earn little or no interest.

• Illiquid assets require substantial transaction

costs in terms of time, effort/fees to convert them to
funds for payment.

• But they generally earn a higher interest rate or rate of

return than monetary assets.
Money Supply
• The central bank substantially controls the
quantity of money that circulates in an economy,
the money supply.

• In ETH., the central banking system is the NBE.

The NBE 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?
Interest rates/expected rates of return on monetary
assets relative to the expected rates of returns on non-
monetary assets.

Risk: the risk of holding monetary assets principally comes

from unexpected inflation, which reduces the purchasing
power of money.

Liquidity: A need for greater liquidity occurs when the

price of transactions increases.
 What Influences Aggregate
Demand of Money?
Interest rates/expected rates of return
A higher interest rate means a higher opportunity cost of holding monetary
assets  lower demand of money.

Prices
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.

Income
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/liquid assets,
which are loosely called “money,” are lent &
borrowed.
• Monetary assets in the money market have low interest
rates compared to interest rates on bonds, loans, &
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
Money Market and the
Foreign Exchange
Market (FXO)
Fig. 15-7: Money Market/Exchange Rate Linkages
Fig. 15-8: Effect of an
Increase in the Money
Supply (US) on Dollar
Interest Rate &
the Dollar/Euro Exchange
Rate
 Changes in the Domestic Money Supply
Money Market <-> FXO
An increase in a country’s money supply causes
interest rates to fall
-> rates of return on domestic currency deposits to fall
-> 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, -> the domestic currency to appreciate
Changes in the Foreign Money Supply

• An increase in the supply of euros causes a

depreciation of the euro

-> (an appreciation of the birr)

• A decrease in the supply of euros causes an

appreciation of the euro
->(a depreciation of the birr)
 Long Run and Short Run
In the SR, prices do not have sufficient time to adjust
to market conditions.
In the LR, prices of factors of production & of output
have sufficient time to adjust to market conditions.

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 LR, there is a direct relationship b/n the inflation
rate & 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 & inputs to change?
1.Excess demand of goods & 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.)

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 LR,

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 LR 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 LR 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 LR response.

• Overshooting is predicted to occur when monetary

policy has an immediate effect on interest rates, but
not on prices & (expected) inflation.

• Overshooting helps explain why exchange rates

are so volatile.
 A Monetary Exchange-Rate Equation
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 , 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