exchange rates and prices

ExchangeRatesandPricesThePurchasingPowerApproachtoExchangeRatesExchangeRatesandPricesTheLawofOnePrice(LOOP)statesthatthesameproductshouldcostthesameineverylocationSupposeanewBMWinGermanycostsE40,000.IntheUS,theidenticalcarcosts,$60,000.Theexchangerateis$1.40/EuroGermanyP*=E40,000USAP=$60,000ExchangeRatesandPriceLevelsImportersbeginbuyingBMWsinGermanyandshippingthemtotheUS.Profit=$60,000–(1.40)(E40,000)=$4,000/CarTradewillcontinueuntiltheprofitopportunityiseliminated.(Note,ingeneral,thiswillinvolveadjustmentsofallthreeprices)GermanyP*=E40,000USAP=$60,000LawofOnePrice(LOOP)GiventhepricesinGermanyandtheUSrespectively,theimpliedzeroarbitrageexchangeratemustsatisfyP=eP*(ZeroArbitrageCondition)e=P/P*=$60,000/E40,000e=1.50($/Euro)PurchasingPowerParityPurchasingpowerparity(PPP)issimplyLOOPappliedtogeneralpriceindices.Consideraneconomywithtwogoods:BMWsandComputers.BothgoodssatisfyLOOP.500,400035000605000300060$),($.),($.P,$P,$PComputerBMW000,300025000405000200040**E),(E.),(E.P,EP,EPComputerBMWEuroPPPPPPeComputerComputerBMWBMW$50.1***RealExchangeRatesRealexchangeratesareusedtomeasureinternationalcompetitiveness(i.e.areforeigngoodsmoreorlessexpensivethandomesticgoods?)RER=eP*=RelativepriceofForeigngoodsPintermsofUSGoodsPurchasingPowerParitysuggeststhattherealexchangerateisequaltoone!!(i.e.allcountriesareequallycompetitive)ProblemswithPPPPriceindicesbetweencountriesarerarelythesamebasketofgoods.400,1400038000602000300060$),($.),($.P,$P,$PComputerBMW4003200022000408000200040**,E),(E.),(E.P,EP,EPComputerBMW***$50.1ePPEuroPPPPeComputerComputerBMWBMW?375.3)400,14($)400,32)(50.1(*EPePRERRelativePurchasingPowerParityAmoreusefulformofPPPis%Changeine=Inflation–Inflation*%ChangeinRER=0Forexample,iftheUSinflationrate(annual)is4%whiletheannualEuropeaninflationrateis2%,thethedollarshoulddepreciateby2%overtheyear.PPPImpliedCurrencyValuesPPPImpliedExchangeRatesCountryExchangeRate(12/2003)InflationDifferential(US-Foreign)PPPimpliedexchangerateActualExchangeRate(12/2004)JPY/USD.009283.5%.00960.00963EUR/USD1.23-.5%1.2241.34GBP/USD1.751.5%1.7761.93CAD/USD.761-.5%.757.820CHF/USD.7911%.799.872AUD/USD.740.5%.7437.768PPP&RealExchangeRatesNotethatadeviationfromPPPimpliesarealexchangeratemovement.Example:EUR/USDInflation(Europe):3%Inflation(US):2.5%ChangeinEUR/USD:9%%inRER=%ine+Inflation(EUR)–Inflation(USD)=9%+3%-2.5%=9.5%(Arealdepreciation)RER=eP*PWantaBigMac?TheEconomistcalculatesthe“BigMac”indexasanindicatorofover/undervaluedcurrencies.Inthisstudy,currentexchangeratesareusedtocalculatethedollarcostofaBigMacaroundtheworld.Remember,LOOPsuggeststhattheyshouldbeequal!!Howaboutacupofcoffee?TheEconomistrecentlybeganacompetitortotheBigMacindexbasedonStarbuckscoffee!ExplainingDeviationsfromPPPTransportationcosts,tariffs,taxes,etc.interferewithLOOPNon-TradedgoodsFixedpricesTradingCosts:AnExampleSupposethatthepriceofgoldinBritainisL210whilethepriceofgoldintheUSis$300TheLOOPexchangerate(USD/GBP)willbeequaltoe=P/P*=$300/L210=$1.43/LIftheexchangeratedeviatesfrom1.43,profitsfromarbitragewouldbeP–eP*(BuyinGB,sellinUS)eP*-P(BuyinUS,sellinGB)TradingCosts:AnExampleNow,assumea$10tradingcostProfitsfromarbitragewouldnowbeP–(eP*+10)(BuyinGB,sellinUS)eP*-(P+10)(BuyinUS,sellinGB)Solvingfortheexchangerategivesusarangeinwhicharbitrageisnotprofitable(Profits=0)(P-$10)/P*e(P+$10)/P*$1.38e$1.47TradingCosts:AnExample11.11.21.31.41.51.61.71.81.92Jan-90Jan-92Jan-94Jan-96Jan-98Jan-00Jan-02Jan-04GBP/USDLowerUpperActualNon-TradedGoods:AnExampleSupposethatinadditiontogold,weaddtheatretickets.TheatreticketsintheUScost$40whileinBritain,similarticketscostL30.PriceIndex=.3(Tickets)+.7(Gold)CPI=.3(40)+.7(300)=$222CPI*=.3(30)+.7(210)=L156Non-TradedGoods:AnExampleCPI*=.3(30)+.7(210)=L156CPI=.3(40)+.7(300)=$222Arbitragewillinsurethenominalexchangeratewillequale=P/P*=300/210=$1.43/LTherealexchangerateequalsRER=e(CPI*/CPI)=1.43(156/222)=1Non-TradedGoods:AnExampleSupposethatthepriceofatheatreticketintheUSincreasesto$50.CPI*=.3(30)+.7(210)=L156CPI=.3(50)+.7(300)=$225thenominalexchangeratestaysate=P/P*=300/210=$1.43/LTherealexchangerateequalsRER=e(CPI*/CPI)=1.43(156/225)=.991(Arealappreciation)AModifiedVersionofPPPGiventheimportanceofrelativeprices(realexchangeratemovements),wecanuseamodifiedversionofPPP.%ChangeinNominalExchangeRate=%ChangeinRealExchangeRate+InflationDifferentialRelativePriceMovementsFixedPrices?Somesuggestthatwhileexchangeratesadjustrapidly,goodspricesadjustmuchmoreslowly.(i.e.ifthenominalexchangeratedepreciatesby10%andpricesarefixed,thentherealexchangeratedepreciatesby10%aswell)Realexchangerateswillbeconstantinthelongrunonceallpriceshavehadtimetoadjust,butwillfluctuateintheshortrun.Nominal/RealExchangeRates50100150200250300Jan-85Jan-86Jan-87Jan-88Jan-89Jan-90Jan-91Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97Jan-98Yen/$RealNominal/RealExchangeRates00.20.40.60.811.21.41.6Jan-80Jan-82Jan-84Jan-86Jan-88Jan-90Jan-92Jan-94Jan-96Jan-98GBP/$RealFixedPrices?Whilerealexchangeratesdoseemtobemeanreverting(i.e.eventua