Lecture 4

Prices Levels and Exchange Rate in the Long-Run

Purchasing Power Parity
Balassa-Samuelson Model
Real interest rate dierential
Some denitions:
Law of one price (LOP): in competitive markets,
free of transportation costs and ocial barrier to
trade, identical goods sold in dierent countries
must sell for the same price once converted in the
same currency.
p
i
= ep

i
where p
i

is the domestic (foreign) price of

good i and e is the nominal exchange rate.
Absolute Purchasing Power Parity (PPP): the ex-
change rate between two currencies should be
equal to the ratio of the countries' price levels.
P = eP

where P (P

) denotes the domestic (foreign) price

level computed as the price of a representative
consumption basket.
LOP always implies PPP if the composition of
the basket of goods is the same across the two
countries) while the reverse is not necessarily true.
Relative PPP: percentage change in the exchange
rate between two currencies over any period equals
the dierence between the percentage change in
national price levels:
p
p
=
p

+
e
e
note that PPP always implies relative PPP but
the reverse is not necessarily true.
Empirical Evidence on PPP and the law of one price:
-changes in national price levels do not tell us much
about changes in the nominal exchange rate;
-law of one price also does not do very well;
-relative PPP does better but still not a good indicator
of exchange rate changes.
-departures from PPP can be higher in the short-run
than in the long-run. (price stickiness in the short
run)
Problems with PPP
-law of one price is based on the absence of trans-
portation costs and barrier to trade. But these costs
can be high enough to prevent goods and service to
be traded across countries.
The existence of nontradeables goods and services
whose prices are not linked internationally allows sys-
tematic deviations from PPP. Shift in domestic and
supply curve that determines the price of nontrade-
ables might cause dierences in price levels across
countries.
-Markets can be non competitive so that prices of
similar goods might dier across countries because of
dierent market structures.
It might happen that a single rm sell the same good
at a dierent price depending on the market
-data are based on dierent commodity baskets so
that there is no reason for exchange rate changes to
reect changes in price levels across countries.
One reason for this dierence is that people living
in dierent countries spend their income in dierent
ways. Relative PPP might capture changes indepen-
dent from dierent preferences.
Decomposition of the Real Exchange Rate:
Consider a situation in which there are tradeable and
non-tradeable goods. We assume that domestic (for-
eign) consumers spend a share (

) of their income
on tradeable goods (T) and a share 1 (1

)
on non-tradeable.(N). Price indexes (using a Cobb-
Douglas utility function) are
P = P

T
P
1
N
P

= P

T
P
1

N
that can be rewritten as
P = P
T

P
N
P
T
!
1
P

= P

N
P

T
!
1

We now dene the Real Exchange Rate (RER) as

RER =
eP

P
=
eP

T
P
T

N
=P

(P
N
=P
T
)
1
Note that RER=1 when PPP holds. So that RER
depends on:

eP

T
P
T
: real exchange rate for tradeable goods (law
of one price);
P
N
=P
T
: relative price of non-tradeable to trade-
able in the Home country;
P

N
=P

T
: relative price of non-tradeable to trade-
able in the Foreign country;
From this we can see that even if the LOP holds ab-
solute PPP can fail if the two countries have dierent
productivity structure and dierent relative prices for
tradeable and non-tradeable. Similarly, if the rela-
tive prices of tradeable and non-tradeable evolve dif-
ferently over time in the two countries then relative
PPP will fail.
Balassa-Samuelson model:
There is a strong correlation between per capita in-
come and the price level across countries. Richer
countries tend to have higher price levels. This is
especially true for the price of non-tradeable. The BS
model oers an explanation for this and shows why
PPP might not hold even if the LOP holds for trade-
able goods.
Assumptions:
Two countries: Home is the poor country and
Foreign (*) is the rich country;
Two goods: tradeable (T) and non-tradeable (NT).
Labor is the only factor of production and is per-
fectly mobile within countries but completely im-
mobile between countries.
Technology: countries are equally productive in
the N sector, but Foreign is more productive in
the T sector:
Y
N
= A
N
L
N
Y

N
= A

N
L

N
; A
N
= A

N
Y
T
= A
T
L
T
Y

T
= A

T
L

T
; A
T
< A

T
The law of one price holds for tradeable.
Prot maximization by rms in all sectors implies:
W
N
= A
N
P
N
and W
T
= A
T
P
T
W

N
= A

N
P

N
and W

T
= A

T
P

T
Labor mobility within countries ensures wage equal-
ization between sectors in each countries:
W

N
= W

T
and W
N
= W
T
This implies that
P
N
P
T
=
A
T
A
N
and
P

N
P

T
=
A

T
A

N
By assumption we have that A
T
< A

T
and A
N
=
A

N
; so that
P
N
P
T
<
P

N
P

T
=
eP

N
eP

T
and if the law of one price holds for traded goods it
follows
P
N
< eP

N
The price level of the non-tradeable is higher in the
rich country and PPP fails.
Low wages in poor countries (due to low productivity
in the tradeable sectors) result in relatively low prices
in non-tradeable sectors, as productivity in these sec-
tor is approximately the same as in rich countries.
Relative PPP implies that international interest rate
dierences equal dierences in countries expected in-
ation rates..
If people expect relative PPP to hold then dierence
between the domestic and foreign interest rates will
be equal to the dierence between expected ination
rates at home and abroad over the relevant horizon.
Recall UIP:
e
e
$=$
e
$=$
e
$=$
u i
$
i
$
while from relative PPP
e
e
$=$
e
$=$
e
$=$
=
UK

US
From which we obtain
i
$
i
$
=
UK

US
This is a long-run relationship between interest rate
dierential and expected dierential in ination (Fisher
Eect).
It means that in the long run a rise in the dier-
ence between home and foreign interest rates occurs
only when expected home ination rises relative to
expected foreign ination.