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An overview of the law of one price and the purchasing power parity (ppp) theory, which establish a relationship between domestic and foreign prices and the exchange rate. It discusses the absolute and relative forms of ppp, the empirical evidence on the ppp theory, and the monetary model of long-run exchange rate determination. The document also covers the concepts of real exchange rate, real appreciation, real depreciation, and the long-term equilibrium real exchange rate. Additionally, it explores the relationship between real interest rates, inflation, and the exchange rate through the real interest parity condition. The document offers a comprehensive understanding of these fundamental theories and their practical implications in the field of international economics and finance.
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The Law of One Price
๏ A T-shirt in Vietnam costs 220000 VND. ๏ The same T-shirt is priced at 10 USD. ๏ Suppose the exchange rate is 1 USD = 22000 VND. โ The prices of the T-shirt in Vietnam and US are the same when they are measured in the same currency.
๏ According to the law of one price, if there are differences in the prices of the same goods in different markets, arbitrage will take place and eventually equalize the prices across markets. ๏ Question 1 : What would happen if the price of the T- shirt is 240000 VND in Vietnam? ๏ Question 2 : What would happen if the price the T- shirt is 11 USD in the US? The Law of One Price
Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP)
P is the domestic price level; P* is the foreign price level; E is the exchange rate (direct quotation)
Purchasing Power Parity (PPP)
๏ The relative PPP theory can be written as follows: โE/E = ฯ-ฯ
or e = ฯ-ฯ
Here ฯ and ฯ
are domestic and foreign inflation rates respectively ฯ = โ P/P ฯ
= โP/P Purchasing Power Parity (PPP)
Monetary approach to the exchange rate
๏ The PPP condition is assumed to hold in the foreign exchange market ๏ E = P/P
๏ The domestic and foreign price levels are determined by the equilibrium condition in the money markets under the assumption of the standard monetary demand function. ๏ P = M S /L(Y,R)
S*
Monetary approach to the exchange rate
๏ the changes in economic policies or economic environment lead to the changes in the money supply and demand ๏ โ the price levels adjust to maintain the equilibrium in money markets. ๏ The exchange rate adjusts in line with the price levels to maintain the PPP. Monetary approach to the exchange rate
Monetary approach to the exchange rate
๏ causes a proportional increase in the domestic price level, ๏ causing a proportional depreciation in the domestic currency (through PPP).
๏ lowers domestic money demand, ๏ increasing the domestic price level, ๏ causing a proportional depreciation of the domestic currency (through PPP).
๏ raises domestic money demand, ๏ decreasing the domestic price level, ๏ causing a proportional appreciation of the domestic currency (through PPP).
Ongoing inflation, the interest rate and the PPP ๏ A continuous rise in the domestic supply of money leads to a continuous and proportional rise in the domestic price level. ๏ The ongoing inflation affects public expectation on prices, thus having an impact on the interest rate. ๏ If the PPP is hold in the long-run, the difference between the domestic and foreign interest rates will be equal to the difference between the expected inflation rates at home and abroad.