International Economics

Lecture 19
Purchasing Power Parity Theory
and Exchange Rates in the Long
Run

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 Outline
1. Law of one price
2. Absolute and relative PPP
3. Relative PPP
4. Empirical evidence and problems with
PPP
5. Long Run Exchange Rate Determination
Models:
A. Monetary approach to exchange rate
determination: long run model
B. Beyond PPP: a general model of the long run
real exchange rate 2
 Motivation
• We now have a theory of how exchange rates
are influenced by interest parity and nominal
shocks in the short term: overshooting behavior.
• Shift attention to the long term.
• Empirically:
– Prices are important in determining exchange rates
in the long term
– Long run real exchange rates show long cyclical
swings
• Why? How?
– Monetary model
– General model and TOT effects 3
 Law of one price
• A no-arbitrage condition for the goods market:
• “Identical goods sold in different countries should
cost the same in different countries when quoted in
the same currency”
• i.e. for good i, the law of one price is:
Pih = Pif* Sh/f
Where Pij is the price of good i in country j and S is the spot price
of Foreign’s currency in terms of Home’s currency
• Problems: too strong, not likely, clearly does not
hold empirically 4
 Absolute Purchasing Power Parity
• “Watered down” version of the law of one price
• Individual prices are not expected to conform to
the law of one price
• Instead: Price levels are equal
– Overall purchasing power of a currency is expected to
be the same across countries.
• Absolute PPP: A representative and identical
bundle of consumption goods should have the
same price across countries when measured in
the same currency
• Formally: Ph = Pf * Sh/f
– P is the average price of a representative bundle of
consumption goods 5
 Relative Purchasing Power Parity
• Absolute PPP is not very useful empirically: data on
price levels which allow cross country comparisons
hard to get.
• Instead, look at what data we DO have: indices, not
levels
– CPI, WPI. Not exactly same goods..
• Relative PPP (totally differentiate absolute PPP, linear approximation):

(∆Ph)/∆Ph = (∆Pf)/∆Pf + (∆Sh/f)/Sh/f

⇒
πh – πf = (∆Sh/f)/Sh/f

• Relative PPP can be upheld when absolute PPP is

not: … this is more of a data issue.
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 PPP and the Real Exchange Rate,
RER
• Real Exchange Rate: The price of foreign goods
relative to domestic goods:

RER1 = (Pf * Sh/f) / Ph

• P: Normally measured using Consumer Price

Index
• Hence, the reference basket of goods to which P
refers is hence NOT equal across the two countries.
• Important point: More weight on domestic goods in
domestic basket and vise versa
• As for Nominal Exchange Rate, an increase in RER
reflects a REAL depreciation 7
PPP and the Real Exchange Rate,
RER
• RER1 = (Pf * Sh/f) / Ph
• Assuming for a second that consumption
patterns are very similar across countries,
then:
• If absolute PPP holds, RER = 1
• If relative PPP holds, RER = constant
– but not necessarily = 1

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 Does PPP hold empirically?
• Empirical test of the Law of one price:
– No support!
• Empirical test of absolute PPP:
– Hypothesis: The prediction that RER = 1
under PPP is used for testing PPP
– Data Problems!! Data on levels of consumer
prices are very scarce across countries – only
few studies and very cumbersome!
– General result: Absolute PPP not found.
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 Does PPP hold empirically?
• Empirical Tests of Relative PPP
– Hypothesis: Relative PPP predicts that RER =
constant in the long term.
– Data: CPI indices provide relative price
changes
– Testing Methodology: We test for RER mean
reversion: The mean of RER is constant over
time while RER can differ from the mean in the
short run.
– General result: Relative PPP NOT found
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Reasons for poor empirical support
for PPP
1. Transport costs and Nontradables
• Transport cost: Wedge between prices across
countries
2. Differences in consumption patters, home bias
• i.e. consumption baskets differ across countries
3. Nontradables, productivity differentials and
wages: The Balassa-Samuelson Effect
4. Imperfect competition and pricing to market
5. Data problems:
– Differences in method and quality of CPI
measurement
– Do we have long enough time series? 11
 Long run exchange rate determination

PPP useful for thinking about long run

interaction between prices and exchange
rates
Two long run models:
1. Monetary Approach to the Exchange
Rate
2. A General Model of Long Run Exchange
Rates
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 1. The flex-Price Monetary Model
• Monetary Approach to the Exchange Rate:
– No good market (Y constant), only monetary effects
on prices and, in turn, interest rates and exchange
rates
• Assumptions:
– PPP holds
– P = Ms / L(Y,R) (P perfectly flexible)
– UIP
– Y is fixed
– Small Country, Rf is exogenous
• Main Results:
– Long run price neutrality
– Fisher Effect and real interest rate parity
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 2. A General Model of Long Run
Exchange Rates

• Monetary approach to long term exchange

rate determination too simple.
– Absolute PPP is not fulfilled empirically
– Real factors also play a part!
• To see how, note that RER and TOT are
close relatives!
– TOT = PX / PIM
– RER = PF * SH/F / PH ≈ 1/TOT
– PH reflects PX, PF * SH/F reflects PIM 14
 2. A General Model of Long Run
Exchange Rates
• Trade theory: no reason to expect TOT = 1 as
PPP predicts for RER.
• Reminder: TOT depends on relative supply and
demand for the country’s production, according
to the Standard Trade Model
• RER is thus a function of relative supply of and
demand for Home’s production:
RERH = RER( RDH , RSH )
+ -
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 2. A General Model of Long Run
Exchange Rates
• Relative Demand:
– Shift in demand toward home production:
– > Higher relative price of Home’s exports
– > Real Appreciation, RER ↓
• Relative Supply
– Outward shift in supply of home production:
– > Lower relative price of Home’s exports
– > Real Depreciation, RER ↑

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 2. A General Model of Long Run
Exchange Rates
• Connect Monetary and Real Economy factors into
one framework:
• General Model of Long Run Exchange Rate
Determination:
RER = PF * SH/F / PH =>

SH/F = RER * (PH / PF)

• Where RER is a function of RS and RD according to
the Standard Trade Model
• And (PH / PF) is determined by demand and supply
for money according to the monetary model: PPP
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 2. A General Model of Long Run
Exchange Rates
• SH/F = S(RER(RS, RD), PH(MsH), PF(MsF))

⇒ SH/F = S( RS(?) , RD (-) , MsH (+) , MsF (-) )

• Where
– RS = relative supply of Home’s goods (affects Y and
hence both P and RER, in opposite directions, thus
?)
– RD = relative demand for Home’s goods
– MsH = money supply in Home
– MsF = money supply in Foreign

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 2. A General Model of Long Run
Exchange Rates
• Finally: Implications for the fisher effect
and real interest rate differentials:

rH – rF = (Et(RERt+1) – RERt ) / RERt

• RER changes allow real interest

differential (deviation from real interest
parity)
• Remember: UIP still holds.
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Summary and Conclusions on PPP
• Absolute PPP states that nominal exchange rates are
linked to the price levels such that the purchasing power
of a given amount of currency is the same across
countries.

• Relative PPP states that price changes give rise to off-

setting nominal exchange rate changes such that the
real exchange rate is constant in time.

• i.e. no real effects on the exchange rate, only monetary

factors matter.

• Empirical evidence of PPP is very poor.

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Summary and Conclusions on PPP
• Long Run Exchange Rate Determination:
• Flex-price monetary model (PPP, UIP and Y constant)
– Result: Fisher Effect: the inflation differential vis-à-vis other
countries is eventually reflected one to one in a nominal
exchange rate depreciation and, in turn, the interest
differential

• Real effects of supply and demand shifts of the RER

• Combine real and monetary factors to get the General
Model of Exchange Rates
– Result: the RER may differ from one
– Real (growth and demand differentials) and Monetary (PPP)
factors determine the nominal exchange rate 21
 Summary and Conclusions on
Exchange Rate Determination
• In the last few lectures, we set out to explain the
Stylized facts on exchange rate movements:
Short term:
– High short term nominal exchange rate volatility
– High correlation between short term nominal and real
exchange rates
Long term:
– Nominal exchange rates movements reflect relative
price movements in the long term
– Long term real exchange rates exhibit long cyclical
movements
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 Short term Exchange Rate
Determination
• Empirical Regularity:
– A. High short term nominal exchange rate volatility
– B. High correlation between short term nominal and
real exchange rates

• How do we explain this?

– A: Sticky prices and overshooting behavior of the
exchange rate: the exchange rate is a “jump” variable
in the short run
– B: Prices are sticky so highly volatile exchange rates
determine RER movements in short term
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 Long term Exchange Rate
Determination
• Empirical Regularity:
– A. Long run nominal exchange rates follow price
movements closely
– B. Long run real exchange rate exhibit long cyclical
swings

• How do we explain this?

– A: Long run price neutrality and PPP. The Fisher
Effect

– B: The real exchange rate is determined by growth,

supply and demand shifts across countries in the long
run 24