Global Environment. The Real Exchange Rate. Francesco Franco. October 22, Nova SBE. Francesco Franco Global Environment 1/28

Transcription

1 Global Environment The Real Exchange Rate Francesco Franco Nova SBE October 22, 2014 Francesco Franco Global Environment 1/28

2 Long Run What explains the long run behavior of exchange rates? Figure : Yen-Dollar Francesco Franco Global Environment 2/28

3 Long Run Framework to form expectations on exchange rates we saw long run changes in expectations, E e,a ectshortrun, so important even for present (in thoery both for capital and current account) key role of national price level, so what determine price levels, why do price change. we will see that we have frameworks but they must be used with judgement. Francesco Franco Global Environment 3/28

4 From LOP to PPP goods market arbitrage enforces broad parity in prices across a su cient range of individual goods: LOP purchasing power parity (PPP) is the simple empirical proposition that, once converted to a common currency, national price levels should be equal some variant of purchasing power parity as an anchor for long-run real exchange rates: fundamental evaluation Francesco Franco Global Environment 4/28

5 Law of One Price The basic building block for any variation of purchasing power parity is the so-called "law of one price" (LOP): P i = EP ú i where P i is the domestic-currency price of good i, Pi ú foreign currency price, and E is the exchange rate. is the check price of ipod remember that indirect taxes (VAT) are paid only where transaction takes place, LOP can only hold for base prices P and not P(1 + ). Tari s, transportation costs, and nontari barriers drive a wedge between prices in di erent countries with the size of the wedge depending on the tradability of the good Francesco Franco Global Environment 5/28

6 Purchasing Power Parity The modern origins of purchasing power parity trace to the debate (Gustav Cassel) on how to restore the world financial system after its collapse during World War. Gustav Cassel (1921, 1922) proposed calculating cumulative CPI inflation rates from the beginning of 1914 and using these inflation di erentials to calculate the exchange rate changes needed to maintain PPP. Absolute (CPI) purchasing power parity requires ÿ Êi P i,euro = S ÿ Ê i P i,us where the sums are taken over a consumer prices P euro = EP us The weights change in time, but also the contents (new goods). The Price level is therefore the price of a representative consumption basket but the level is not as interesting as the change (tipycally the level is expressed in terms of a base year P 2005 = 100) Francesco Franco Global Environment 6/28

7 Relative PPP Relative PPP requires only that the rate of growth in the exchange rate o set the di erential between the rate of growth in home and foreign price indices which can be written: P euro,t /P euro,t 1 =(E t /E t 1 )(P us,t /P us,t 1 ) where fi t = P t /P t 1 1 E t /E t 1 = 1 + fi euro,t 1 + fi us,t Francesco Franco Global Environment 7/28

8 The Price level in the LR So far we are trying to determine the long run exchange rate S from the price level of the two jursdictions. So one question is what determines the long run price level P. According to monetary theory M s = PL(Y, i) where M s is the money supply we have analyzed in the monetary policy section and L(Y, i) is the demand of real balances. Hence the idea that given output, the price level is a monetary phenomenom. Key point is that monetary phenomenom is a ecting also output and the debate can be framed on the speed: how fast changes transmit into P. Francesco Franco Global Environment 8/28

9 Monetary equilibrium & PPP Consider the money market equilibrium and the PPP Other things equal P = Ms L(Y, i) P = EP ú an increase in M increase the price level and depreciate the exchange rate a rise in interests rates increases P and depreciate the exchange rate (contrary to UIP with given expectations) Francesco Franco Global Environment 9/28

10 PPP & UIP combining short run and long run Take the relative PPP in expected form E e /E =(P e euro/p euro ) / (P e us/p us ) E E e = 1 + fie euro 1 + fius e and combine it with UIP:1 + i euro t = i $ t 2 E e t+1 E t i euro i us =ƒ fi e euro fi e us Francesco Franco Global Environment 10/28

11 PPP & UIP combining short run and long run All else equal a rise in a country s expected inflation will eventually cause an increase in the nominal interest rate. This is the Fisher e ect. This e ect explains the e ects of the interest rate on exchange rate in the monetary approach: in the long run an increase in the interest rate can only occur with a higher inflation rate and therefore a depreciation In the short run the price level does not adjust (only UIP) Debate on speed, what is the short run what is the long run Francesco Franco Global Environment 11/28

12 Law of One Price Empirical Evidence Study after study has found that deviations from the law of one price are remarkably volatile across a surprisingly broad range of goods Generally speaking, relative nominal prices are far less volatile than exchange rates Price di erentials for basic goods at neighboring supermarkets, or even at di erent stalls in the same market place Within a country, the relative price of the same good across two cities does appear to be a function of the distance between them (Engel Rogers 1995) The "border" e ect on relative price volatility is equivalent to adding anywhere between 2,500 to 23,000 miles between cities Francesco Franco Global Environment 12/28

13 Purchasing Power Parity There is consensus on a couple of basic facts real exchange rates (nominal exchange rates adjusted for di erences in national price levels) tend toward purchasing power parity in the very long run speed of convergence to PPP is extremely slow; deviations appear to damp out at a rate of roughly 15 percent per year short-run deviations from PPP are large and volatile the one-month conditional volatility of real exchange rates is of the same order of magnitude as the conditional volatility of nominal exchange rate Francesco Franco Global Environment 13/28

14 Law of One Price Non tradables Figure : Big Mac Index Francesco Franco Global Environment 14/28

15 The Real Exchange Rate The REER REER = E P us P euro where P us contains more US goods, and P euro contains more euro goods both P contain non-tradables...need the right P but REER is important for external equilibrium (figure 16.4) Now if there is a LR REER and we know the two P, wecan determine the long run E Francesco Franco Global Environment 15/28

16 The Real Exchange Rate Figure : The US real echange rate and current account Francesco Franco Global Environment 16/28

17 The Real Exchange Rate Movement at di erent frequencies Short Run: movements in nominal exchange rate Medium Run: movements in costs, taxes, competition Long Run: movements in productivity movement in monetary factors Francesco Franco Global Environment 17/28

18 The Real Exchange Rate Short Run If prices are sticky, in the short run movement in the REER are driven by the nominal exchange rate Francesco Franco Global Environment 18/28

19 The Real Exchange Rate Exchange rate and Money: overshooting Figure : Overshooting after permanent MP Francesco Franco Global Environment 19/28

20 Review Exchange rate an Money: overshooting Figure : Overshooting after permanent MP Francesco Franco Global Environment 20/28

21 The Real Exchange Rate Medium Run In the medium run, when prices adjust P = µ(1 + )W A where µ :is goods market competition, is labor tax, W is nominal wage (input cost) and A is productivity. so that RER = A A ú µ ú (1 + ú)w ú µ(1 + )W E without E or with little wage adjustment di short run. cult to change RER in Francesco Franco Global Environment 21/28

22 Review Medium Run Legend µ: mark-up, measure of competition in goods markets : tax on labour W : nominal wage A:productivity Francesco Franco Global Environment 22/28

23 Review Medium to Long Run: Non Tradables Consider P = P T P1 N and P ú = P ú T Pú1 N and p = P N P T.Now with perfect competition in tradables the LOP holds for P T = EPT ú which means that ReeR = E 1 P ú1 N P 1 N and the real echange rate only depends on the non tradables. This is how they a ect directly competitiveness. Francesco Franco Global Environment 23/28

24 The Real Exchange Rate Long Run: Harrod-Balassa-Samuelson e ect Consider P = P T P1 N and P ú = P ú T Pú1 N and p = P N P T letting a variable with a hat denoting a growth rate: and ˆP ˆP ú =(1 )(ˆp ˆp ú ) we can show that if labor share is larger in non-tradable versus tradable it follows that home will experience a real appreciation if its producivity growth advantage in tradables exceeds its productivity growth advantage in nontradables Francesco Franco Global Environment 24/28

25 The Real Exchange Rate Long Run: Harrod-Balassa-Samuelson e ect Francesco Franco Global Environment 25/28 Figure : Real per capita incomes and price levels

26 The Real Exchange Rate Long Run: Harrod-Balassa-Samuelson e ect Francesco Franco Global Environment 26/28

27 The Real Exchange Rate Long Run: monetary factors See above Francesco Franco Global Environment 27/28

28 Readings *Krugman, Obstfeld and Melitz, chapter Francesco Franco Global Environment 28/28