CHAPTER

15 International Economics

Exchange Rate Determination

101
 Learning Goals:
After studying this chapter, you should be able to:
n Understand the purchasing –power parity theory
(PPP) and why it does not work in the short run
n Understand how the monetary and the portfolio
balance models of the exchange rate work
n Understand the causes of exchange rate
overshooting
n Understand why exchange rates are so difficult to
forecast

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Contents
n Purchasing - Power Parity Theories
n Monetary approach to the BOP and exchange
rates
n Portfolio balance model and exchange rates
n Exchange rate dynamics
n Empirical evidence on the monetary
approach and the portfolio balance approach,
and on exchange rate forecasting

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Purchasing – Power Parity Theory
(PPP theory)
n Purchasing power of currency changes due
to inflation or deflation

n When there is inflation, price level

increases, quantity of goods that can be
purchased by one unit of currency declines
Þ Thus, the purchasing power also decline and vice
versa

104
 Purchasing – Power Parity Theory
(PPP theory)
n PPP theory:
v Explains the relationship between exchange rate
and inflation
v Based on “Law of one price” and works in long
run
v Exchange rate of a commodity is determined on
the basis of the purchasing power of the currency

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Purchasing – Power Parity Theory
(PPP theory)
n There are two versions to the PPP theory:

v The absolute PPP (positive version), and

v The relative PPP (comparative version)

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Absolute Purchasing – Power Parity Theory

n The absolute PPP theory: The equilibrium

exchange rate between two currencies is
equal to the ratio of the price levels in the two
nations.
n R = P/P*
Ø R is the exchange rate or spot rate
Ø P is the general price level in the home country
Ø P* is the general price level in the foreign country
Example:
if 1kg of paddy rice in the U.S is $ 2 and € 1 in the EU
è Then R ($/ € ) = $2/€1= 2

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Law of One Price

n The Law of One Price states that the price of an

identical good will be the same throughout the world,
regardless of which country produces it.

n The Law of One Price states that a given commodity

should have the same price (so that the purchasing
power of the two currencies is at parity) in both
countries when expressed in terms of the same
currency.
Law of One Price (cont’d)

Example 1: If
§ Pw = $0.50 in the US
§ Pw = $1.50 in the UK
Þ Firms would purchase Wheat in the US and resell
it in the UK, at a profit, until Pw = $1 in both
economies.
Example 2: If the dollar/pound exchange rate is
$1.50 per pound, a sweater that sells for $45 in
New York must sell for £30 in London.

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 Purchasing Power Parity (cont’d)

n The Relationship Between PPP and the Law of

One Price
n The law of one price applies to individual
commodities, while PPP applies to the general
price level.
n If the law of one price holds true for every
commodity, PPP must hold automatically for the
same reference baskets across countries.
n Proponents of the PPP theory argue that its
validity does not require the law of one price to
hold exactly.
 Exchange Rates in the Long Run: Theory of
Purchasing Power Parity (PPP)

n Problems with PPP

n All goods are not identical in both countries
(i.e., Toyota versus Chevy)
n Many goods and services are not traded
(e.g., haircuts, family doctors, land, cement
and bricks, etc.)
n This law applies only in competitive markets
free of transport costs and official barriers to
trade.
n…
 Relative Purchasing – Power
Theory
The relative PPP theory: the change in the exchange rate over a
period of time should be proportional to the relative change in the
price level in the two nations over the same period

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Relative PPP: Challenges
n Balassa- Samuelson effect (1964)- ratio of the price of
non-traded to the price of traded goods and services is
systematically higher in developed countries than
developing countries. Why?
§ Labor productivity in traded goods being higher in
developed than developing countries, but about the same
in many non traded goods and services sectors.
§ Services and non traded goods should receive almost
same salary as traded in developed countries for people to
remain in the sector.
Relative PPP: Challenges (cont’d)

n This makes prices to be high in developed

countries of non traded goods
e.g. a haircut may cost $20 in the US and averages
$1.5 in developing countries.

n Therefore, Relative PPP will tend to predict

overvalued exchange rates for developed
countries and undervalued for developing
countries.

114
 Assets Market Approach for
Determination of Exchange Rate
n Monetary Approach
§ Deal with the demand and supply of money
n Portfolio Approach
§ The portfolio balance approach points out the
imperfect substitution between home assests
and foreign assets

115
Monetary Approach to the BOP under Fixed
Exchange Rates

n Developed by Robert Mundell and Harry Johnson (1960)

n How exchange rates and monetary factors interact in the
long run.
n BOP as a monetary phenomenon
n Money play crucial role in adjusting BOP and determine
exchange rate
n Exchange rates depend on demand for money and supply of
money at home and abroad
n Demand for money depends on real income, prices, interest
rates
n Supply of money is controlled by central banks

116
 Monetary Approach to the BOP under Fixed
Exchange Rates (cont’d)
The demand for money The supply of money
Md= k PY Ms = m (D+F)
• Md: Quantity demanded of nominal • Ms: The nation’s total money supply
money balances • m: Money multiplier (assumed constant over tim)
• k = 1/V (velocity of circulation of money) desired • D: Domestic component of the nation’s
ratio of nominal money balances to monetary base (domestic credit created by
nominal national income central bank)
• P: Domestic price level • F: International or foreign component of
• Y: Real output the nation’s monetary base

=> PY: National Income => D+F is monetary base or high powered
money
BOP adjustment:
§ In equilibrium Ms = Md
§ An increase in Md (probably from an increase in Y) can be satisfied by an increase in D or F or BOP surplus
§ If the central bank does not increase D then the excess demand for money will be satisfied by an increase
in F
§ If an increase in D and Ms without a change in Md, money flows out of the nation and leads to a fall in
F or BOP deficit
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Monetary Approach – Flexible Exchange rates

n Under flexible exchange rates, BOP are corrected

automatically moving exchange rates- without any
international flow (inflow/outflow) of money or
reserves.
n Adjustment takes place as a result of the change in
domestic prices that accompanies the change in the
exchange rate
n Example: a deficit in the BOP (resulting from an excess
money supply) leads to an automatic depreciation of
the nation’s currency, which causes prices and therefore
the demand for money to rise sufficiently to absorb the
excess supply of money and automatically eliminate BOP
deficit.
Monetary Approach – Flexible Exchange rates
(cont’d)
n A surplus in the BOP (resulting from an excess demand
for money), automatically leads to an appreciation of
the nation’s currency, and decline in price level, thus
eliminating the excess demand for money and the BOP
surplus.
n Exchange value is purely determined by rate
of money growth and real income.
n Excessive money growth in the nation overtime
leads to a currency depreciation
n Inadequate money growth in the nation leads to
a currency appreciation.
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Figure 15.3: Relative Money Supplies and Exchange
Rates
 Monetary Approach – Fixed and Flexible
Exchange rates (cont’d)

BOP adjustment (Difference):

§ Under Fixed exchange rates:
BOP adjustment through international flow of reserves
and money

§ Under flexible exchange rates:

BOP adjustment through changes in exchange rates
 Monetary Approach to Exchange Rate
Determination

n Assumes no barriers to trade, no transport cost, and PPP

then according to law of one price commodity must be same
in price in all nations.
ü P = RP* and R = P/P* [15-1]
ü If Md= kPY and M*d = k*P*Y*
ü In equilibrium Md= Ms M*d = M*s
ü Therefore M*s/Ms= kP*Y*/kPY
ü Dividing both sides: by P*/P and M*s/Ms
ü Then P/P*= Ms k*Y*/M*s kY ó R= Ms k*Y*/Ms*kY
[15-7]
ÄSince k*, Y*, k, Y are assumed to be constant, R is constant as long as Ms
and M*s, remain unchanged. The changes in R are proportional to
changes in Ms and inversely proportional to changes in Ms*.
Ä Theory depends on PPP and Law of One Price
Ä Equation 15-7 was derived from money demand which does not include
interest rates
Expectations , Interest Differentials,&
Exchange rates
n Exchange rates depends on inflation expectations and expected
changes in exchange rates.
n % changes in expected inflation will lead to equal % changes in
exchange rates
n Using uncovered interest argument- an expected change in
exchange rate will lead to real change in exchange rate (14.6A)
n Foreign and domestic bonds are perfect substitutes.
i - i* = EA
i = Interest rate in the home country ($)
i* = Interest rate in the foreign country (€)
EA = The expected % appreciation per year of € with the respect to $

Ä If i < i* è returns on investments are lower in the US than in the

EU, then (€) will be expected to depreciate
A Long-Run Exchange Rate
Model Based on PPP (Summary)

n The monetary approach makes a number of

specific predictions about the long-run effects on
the exchange rate of changes in:
n Money supplies
§ An increase in the U.S. (European) money supply causes
a proportional long-run depreciation (appreciation) of
the dollar against the euro.
n Interest rates
§ A rise in the interest rate on dollar (euro) denominated
assets causes a depreciation (appreciation) of the dollar
against the euro.
n Output levels
§ A rise in U.S. (European) output causes an appreciation
(depreciation) of the dollar against the euro.
Slide 15-124
 Portfolio Balance Model (Asset Market
Approach) and Exchange Rates
n Portfolio balance models of flexible exchange
rates focus on the role of asset stocks in the
determination of exchange rates: short-run
exchange-rate adjustments are determined in
asset markets

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 Portfolio Balance Model (Asset Market
Approach) and Exchange Rates
n Exchange rates are determined in the process of
equilibrating the stock or total demand and
supply of financial assets
n Individuals and firms would consider holding
financial assets in the forms of domestic
money, domestic bond and foreign bond
(portfolio)
n The incentive to hold bonds depends on yield
n Foreign and domestic bonds are not the perfect
substitutes (in terms of risk and return)

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 Portfolio Balance Model (Asset Market
Approach) and Exchange Rates

n Demand for bonds:

§ Yield and market rate of interest
o For foreign bonds and domestic bond
§ Opportunity cost is important:
o Economization on the use of money
o Higher the yield or interest, smaller is the Md
and vice versa
§ Nature of investor (risk averse/lowers)

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Portfolio Balance Model (Asset Market
Approach) and Exchange Rates
n Under flexible exchange rates:
n A rise in domestic rate of interest:
§ Demand for domestic bonds increases and
reduces the demand for money
§ Capital inflow
§ Investors sell foreign bonds
§ Exchange rate decreases è Appreciation or
Depreciation???

128
Portfolio Balance Model (Asset Market
Approach) and Exchange Rates
n A rise in foreign rate of interest:
• Demand for foreign bonds increases
• Investors sell domestic bonds
• Increases the demand for money
• Exchange rate increases è Depreciation or
Appreciation???

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