Open Economy: Purchasing Power Parity

Learning Objectives• Understand the difference between nominal and

real exchange rates.• Understand the differences between fixed

exchange rate systems and flexible exchange rate systems.

• Understand how the theory of purchasing power parity explains the determination of interest rates.

• Understand how the theory of interest rate parity explains the determination of interest rates.

Exchange Rates

• An exchange rate is the price of one currency in terms of another.

• Exchange rates are important because exports, imports and all international financial transactions are affected by the prices at which currencies exchange for one another.

Nominal Exchange Rate

• Nominal exchange rate: the relative price of the currency of two countries.– e = yen/dollar = 120/1 = 120

• One dollar buys 120 yen– e = dollar/yen = 1/120 = 0.0083

• 120 yen buy 0.0083 dollars.

Real Exchange Rate

• Real exchange rate is re = e x PUSA /PJ

– The real exchange rate can be expressed as:• re = (Y/PJ)/($/PUSA) = Y/$ x (PUSA/PJ)

where• Y = Yen• $ = Dollars• PUSA = Price level in the USA

• PJ = Price level in Japan

Exchange Rate Systems

• Fixed Exchange Rates– A fixed exchange rate system is one in which

exchange rates are set at officially determined levels and are changed only by direct governmental action.

Fixed Exchange Rate Definitions

• When the value of a currency in terms of another is fixed by the government,– Devaluation: a reduction in the official value of

a currency.– Revaluation: an increase in the official value of

a currency.

Fixed Exchange Rates

• In a system of fixed exchange rates, the central bank must be prepared to offset imbalances in both demand and supply by government sales or purchases of foreign exchange.

• Each country’s central bank must intervene in the foreign exchange market to prevent that country’s exchange rate from going outside a narrow band on either side of its par value.

Fixed Exchange Rates: Example

• Let the exchange value of the Hong Kong dollar be set such that it is overvalued relative to its current market value.– Hong Kong must drive up the value of the HK$

by using its foreign reserves to buy the HK$ in the world market .

Fixed Exchange Rates: Example

• Let the exchange value of the Hong Kong dollar be set such that it is undervalued relative to its current market value.– Hong Kong must drive down the value of the

HK$ by selling them in the world market, thus gaining foreign reserves.

Fixed Exchange Rate: Example

Overvalued Undervalued

D

S

D

S

QQ

$/HK$ $/HK$

Peg Peg

Market

Market

0 0

Loss of Reserves

Gain of Reserves

Fixed Exchange Rates: Advantage

• Advantage:– Less uncertainty in the near future about

exchange rates.• Developing countries use fixed exchange rates so

that the rest of the world will be willing to hold their currencies.

Fixed Exchange Rates: Disadvantages

• Disadvantages:– Requires large amounts of currency reserves.– May require difficult macroeconomic policy

adjustments and a loss of control of domestic economic policy.

– Can be used to promote an inefficient pattern of trade and specialization.

Exchange Rate Systems

• Flexible Exchange Rates– A flexible exchange rate system is one in which

exchange rates are determined by conditions of supply and demand in the foreign exchange market.

– Flexible exchange rate systems are also known as floating exchange rate systems

Flexible Exchange Rate Definitions• When the value of a currency in terms of

another is determined by the market,– Appreciation: an increase in a country’s

exchange rate due to a change in demand and/or supply.

– Depreciation: a decrease in a country’s exchange rate due to a change in demand and/or supply.

Flexible Exchange Rates: Examplec/$

QD$

S$

If supply of dollars exceeds demand, the dollar depreciatesand the euro appreciates.

If demand for dollars exceeds supply, the dollar appreciatesand the euro depreciates.

Q1 Qeq Q20

Flexible Exchange Rates: Advantages and Disadvantages

• Advantages:– Exchange rates re-equilibrate automatically.– Promote a globally efficient pattern of

production specialization and international trade.

• Disadvantages:– Market volatility.– Increase transactions costs associated with

dealing with foreign currency.

Exchange Rate Determination: Long Run

• In the long run, exchange rates can be explained with the concept of purchasing power parity (PPP).– Purchasing power parity states that if

international arbitrage is possible, the price of a good in one nation should be the same as the price of the same good in another nation, adjusted for the exchange rate.

PPP: Simple Example

• Assume that the U.S. and Canada produce identical bushels of wheat and that the exchange rate is $1.00 Canadian for $1.00 USA.

• Let the price of wheat in Canada be $3/bushel and the price of wheat in the USA be $2.50/bushel.

• What will happen?

PPP: Example

• Canadians will buy U.S. wheat. In order to do this, they must first buy U.S. dollars.– Supply of Canadian dollars in the global

marketplace increases.– Demand for U.S. dollars in the global

marketplace increases• The Canadian dollar depreciates and the U.S

dollar appreciates.

PPP: Simple Example

• In the long run, these transactions bring about a single price for U.S. and Canadian wheat.

• Conclusion:– A rise in the price level puts downward

pressure on a currency.– A fall in the price level puts upward pressure

on a currency.

Why PPP Works Poorly in the Short Run

• PPF Assumptions:– All goods are identical in both countries.– All goods and services are traded across borders.– Both countries have similar levels of productivity.– Consumers do not prefer one country’s goods

over another’s.– No tariffs or quotas.

Exchange Rate Determination: Short Run

• The modern asset market approach to explain exchange rate determination emphasizes financial flows.

• In the short run, decisions to hold domestic or foreign assets play a more important role than trade.

Exchange Rate Determination: Interest Rate Parity

• Interest rate parity says that the higher domestic real rates of interest are relative to foreign real interest rates, the higher will be the value of the domestic currency, other things remaining the same.

Interest Rate Parity: Assumptions• Foreign and U.S. deposits have similar risk and

liquidity characteristics.• There are few impediments to capital mobility.

– Foreigners can easily purchase American assets and Americans can easily purchase foreign assets.

• Therefore, foreign and American assets are perfect substitutes.

Expected Return

• Demand for dollar assets vis a vis foreign assets depends on the relative expected return on the assets.– A higher expected return on dollar assets relative

to foreign assets results in a higher demand for dollar assets.

– A higher expected return on foreign assets relative to dollar assets results in a higher demand for foreign assets.

Relative Expected Return: Foreign Perspective

• The relative expected return on dollar assets held by a foreigner depends on the difference between the domestic and foreign interest rates and the expected change in the exchange rate of the dollar.

Relative Expected Return: Example

• RETE = iusa – if + /\e$/e$

– If iusa = 10%, if = 5%, and /\e$/e$ = 5%, the relative expected return from the foreign perspective on the USA asset is 10%.

– If iusa = 10% , if = 5%, and /\e$/e$ is – 5%, the relative expected return from the foreign perspective on the USA asset is 0%.

Interest Rate Parity Condition

• For existing supplies of both dollar and foreign assets to be held, it must be true that there is no difference in their expected returns.– The relative expected return must equal zero.

• Relative RETE = id – if + /\e$/e$ = 0

id = if – /\e$ /e$

Interest Rate Parity Condition: Implications

• If the domestic rate is below the foreign interest rate, positive expected appreciation of the domestic currency is expected.• The expected appreciation compensates for the

lower domestic interest rate.• 8% = 10% – x

Interest Rate Parity Condition: Implications

• If the domestic rate is above the foreign interest rate, positive expected appreciation of the foreign currency is expected.– Positive expected appreciation of the foreign

currency equals negative expected appreciation of the domestic currency.

– The expected appreciation compensates for the lower foreign interest rate.

• 10% = 8% – x

Interest Rate Parity: Example

• Assume that U.S. interest rates are higher than those in other countries.

• The high rates of return on U.S. financial assets attract foreign buyers.– In order to buy U.S. financial assets, foreigners

must first buy dollars.• The demand for dollars increases in the global marketplace

and the dollar appreciates.• The supply of the foreign currency increases in the global

marketplace and it depreciates.

Determinants of the Exchange Rate: Summary Table

An Increase in Change in the Reason Exchange Rate

Domestic output Fall Demand for imports& supply of dollars rise

Foreign output Rise Demand for domesticexports & dollars rises

ROW demand for domestic Rise Demand for goods and goods dollars rises.

Real domestic interest rate Rise Demand for dollars rises

Foreign interest rate Fall Supply of dollars rises

Expected value of the Rise Demand for dollars risesdollar