Reinert/Windows on the World Economy, 2005 Exchange Rates and Purchasing Power Parity CHAPTER 13.

Reinert/Windows on the World Economy, 2005

Exchange Rates and Purchasing Power Parity

CHAPTER 13


2

Introduction

Exchange rates matter in many different ways to many different constituencies in the world economy

Much of this section on international finance will be directly or indirectly concerned with exchange rates


3

The Nominal Exchange Rate

Relative price of two currencies Often expressed as number of units of local or home currency

required to buy a unit of foreign currency

We will usually view Mexico (peso) as our home country and United States (dollar) as our foreign country

Nominal or currency exchange rate (e) is

If e increases the value of the peso (home currency) falls If e decreases the value of the peso (home currency) rises e and the value of the peso are inversely related

• e is often graphed as its inverse which is equal to the value of the peso

dollar

pesos

currencyforeign

currencylocale


4

Table 13.1. Nominal Exchange Rates, October 9, 2002 (per US dollar)


5

Figure 13.1. The Value of the Peso Scale


6

The Real Exchange Rate

Measures the rate at which two countries’ goods trade against each other

Makes use of the price levels in the two countries under consideration PM—overall price level in Mexico (the home

country) PUS—overall price level in the United States (the

foreign country)

M

US

P

Pere


7

Table 13.2. Changes in the Real Exchange Rate


8

The Real Exchange Rate

Suppose that the price level in the United States rises Takes more Mexican goods to purchase US goods Represents a fall in the real value of the peso

Suppose that the price level in Mexico rises Takes fewer Mexican goods to purchase US goods Represents a rise in the real value of the peso

Suppose that the nominal exchange rate increases Takes more Mexican pesos to buy a US dollar and, therefore, more

Mexican goods to buy US goods Represents a fall in the real value of the peso

Real exchange rates affected by both nominal exchange rates and price levels


9

Exchange Rates and Trade Flows

Changes in e have an impact on trade flows Consider the case of Mexico’s imports and exports

World prices (PW) are typically in US dollar terms Mexican prices (PM) are in peso terms

• Relationship between the peso and world prices of Mexico’s import (Z) goods can be expressed as

WZ

MZ PeP

• is in dollar terms Multiplying it by e gives us in peso terms

WZP

MZP


10


Suppose e were to increase (the value of the peso falls) Movement down the scale in Figure 13.1 increases the

peso price of the imported good in Mexico Import demand consequently decreases

Suppose e were to decrease (the value of the peso rises) Movement up the scale in Figure 13.1 decreases the

peso price of the imported good in Mexico Import demand consequently increases


11

Figure 13.2. The Value of the Peso and Mexico’s Imports


12

Figure 13.3. The Value of the Peso and Mexico’s Exports


13


Relationship between the peso and dollar prices of Mexico’s exported (E) goods can be expressed as

Suppose e were to increase (the value of the peso falls) Movement down the scale in Figure 13.1 increases the

peso price of the export good in Mexico Export supply in Mexico consequently increases

• Mexican firms now have more of an incentive in peso terms to export

WE

ME PeP


14


Suppose e were to decrease (the value of the peso rises) Movement up the inverse scale in Figure 13.1

decreases the peso price of exports in Mexico Export supply consequently decreases

Can put the relationships of Figures 13.2 and 13.3 together Figure 13.4 represents the positive relationship

between value of peso and trade deficit, or Z – E


15

Figure 13.4. The Value of the Peso and Mexico’s Trade Deficit


16

The Purchasing Power Parity Model

Begins with the hypothesis that the nominal exchange rate will adjust so that the purchasing power of a currency will be the same in every country

Implications of hypothesis Purchasing power of a currency in a given country is inversely related to

price level in that country• For example, purchasing power of the peso in Mexico can be expressed as

The higher the price level in Mexico the lower the purchasing power of the peso

Purchasing power of peso in United States is more complicated• Need rate at which a peso can be exchanged into dollars, or 1/e• Need purchasing power of a dollar in United States, or 1/PUS

• Purchasing power of a peso in United States is

MP1

USPe11


17

PPP Equation

PPP hypothesis is

Invert the equation

Divide both sides of the above equation by PUS to obtain PPP equation

USM PeP

111

USM PeP

US

M

P

Pe


18

Meaning of PPP Equation

Suppose PM were to increase According to the PPP model, e would increase

• Value of the peso would move down the scale in Figure 13.1

Suppose PUS were to increase According to the PPP model e would decrease

• Value of the peso would move up the scale in Figure 13.1

Nominal value of the peso adjusts to changes in its real purchasing power in the two countries


19

Meaning of PPP Equation

Restrictiveness of PPP model can be seen when we re-express it in a third equation Multiplying both sides of the PPP equation by

Compare this equation with real exchange rate

Obtain modified PPP equation

M

US

PP

1M

US

P

Pe

reP

Pe

M

US


20

PPP Model as Special Case

PPP model is a special case of the real exchange rate Implies that real exchange rate is fixed at unity

• No change in real exchange rate However real exchange rates do change therefore there

must be important elements of the real world that the PPP theory ignores

PPP assumes all goods entering into the price levels of both countries are internationally traded

Phenomenon of product differentiation Allows for separate markets (and therefore prices) for

import and domestic varieties of a good


21

PPP Model as Special Case

Real exchange rate equation captures reality at any point in time PPP relationship never holds exactly

PPP equation gives a sense of a long-term tendency towards which nominal exchange rates move absent other changes


22

Exchange Rate Exposure

If sales from either exporting or foreign direct investment are not denominated in the currencies of the firms’ home countries Exchange rate exposure issues arise

Suppose that the €/US$ exchange rate is currently at a value of 1.00

Suppose also that a US firm is expecting euro revenues of €1.0 million Current exchange rate (spot rate) suggests US firm might be

expecting dollar revenues of US$1.0 million Suppose, however, that the spot rate moves to e = 1.25 (a dollar

value of the euro of $0.80)• Now takes more euros to purchase a dollar—dollar revenues shrink to

$800,000


23

Forward Markets

For some currencies forward rates also exist Rates of current contracts for “forward” transactions in currencies

• Usually for one, three, or six months in the future

If the forward rate of the euro (€/US$) is exactly the same as the spot rate Euro is “flat”

If the forward rate of the euro is above the spot rate Euro is at a “forward discount”

If the forward rate of the euro is below the spot rate Euro is at a “forward premium”

Hedging exchange rate exposure requires that firms have expectations or forecasts of future spot rates that they can compare to forward rates

Reinert/Windows on the World Economy, 2005 Exchange Rates and Purchasing Power Parity CHAPTER 13.

Documents

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