The Law of One Price and Purchasing Power Parity (PPP), Summaries of Economics

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Price Levels and the Exchange

Rate in the Long Run

Objective

 This lesson analyzes the determination of the

exchange rate in the long-run, taking into account

both monetary and non-monetary factors in the

determination of the exchange rate

The Law of One Price

 The law of one price : Under the assumption of perfect

competition and if there are no transportation costs and trade

barriers, the same good must sold for the same price in

different markets.

 Example:

 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. ➔ 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)

 The PPP theory states that the exchange rate must be

equal to the ratio of the domestic and foreign price levels.

 A decline in the purchasing power of the domestic

currency is associated with a proportional depreciation of

the domestic currency. By contrast, an increase in the

purchasing power of the domestic currency results in a

proportional appreciation of the domestic currency.

 The PPP theory comes in two forms: absolute PPP and

relative PPP.

Purchasing Power Parity (PPP)

 The absolute PPP establishes the relation between domestic

price, foreign price and the exchange rate in the absolute term

P = E×P

or

E = P/ P

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 is derived from the absolute PPP.

 The relative PPP theory asserts that the percentage change in

the exchange rate must be equal to the difference between the

percentage changes in the domestic and foreign price levels.

 The relative PPP theory can be written as follows: ∆E/E = π-π

or e = π-π

Here π and π

are domestic and foreign inflation rates respectively π = ∆ P/P π

= ∆P/P Purchasing Power Parity (PPP)

• The law of one price and the PPP theory
  • The monetary model of the long-run exchange

rate determination

• The empirical evidence on the PPP theory
• The generalized model of the long-run exchange rate

determination

• The international price differences and real interest

parity

Monetary approach to the exchange rate

 The monetary model of the exchange rate (flexible

price model) is a combination of the PPP theory

and the theory of money demand and supply.

 The monetary model is based on the assumption of

 full employment and

 the flexibility of prices and wages, and

 a long-run model of the exchange rate determination.

 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)

 P

= M

S*

/L(Y

,R

Monetary approach to the exchange rate

 In the monetary model of the exchange rate,

 the changes in economic policies or economic environment lead to the changes in the money supply and demand  ➔ 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

▪ Money supply : a permanent rise in the domestic money

supply

 causes a proportional increase in the domestic price level,  causing a proportional depreciation in the domestic currency (through PPP).

▪ Interest rates : a rise in the domestic interest rate

 lowers domestic money demand,  increasing the domestic price level,  causing a proportional depreciation of the domestic currency (through PPP).

▪ Output level: a rise in the domestic output level

 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.