Classical Economics Relative Prices Classical Economics n Classical

  • Slides: 77
Download presentation
Classical Economics & Relative Prices

Classical Economics & Relative Prices

Classical Economics n Classical economics relies on three main assumptions:

Classical Economics n Classical economics relies on three main assumptions:

Classical Economics n Classical economics relies on three main assumptions: Markets are perfectly competitive

Classical Economics n Classical economics relies on three main assumptions: Markets are perfectly competitive n All prices are flexible n Markets clear (equilibrium) n

Classical Economics n Classical economics relies on three main assumptions: Markets are perfectly competitive

Classical Economics n Classical economics relies on three main assumptions: Markets are perfectly competitive n All prices are flexible n Markets clear (equilibrium) n n One key result is that all real variables are independent of monetary policy (money neutrality)

Savings, Investment, and the Trade Balance n Recall that in a closed economy, demand

Savings, Investment, and the Trade Balance n Recall that in a closed economy, demand for loanable funds (supply of marketable securities) must equal the supply of loanable funds (demand for marketable securities)

Savings, Investment, and the Trade Balance n Recall that in a closed economy, demand

Savings, Investment, and the Trade Balance n Recall that in a closed economy, demand for loanable funds (supply of marketable securities) must equal the supply of loanable funds (demand for marketable securities) S = I + (G-T) S = Private Savings I = Private Investment (G-T) = Government Deficit/Surplus

Savings/Investment in a Closed Economy Without access to world capital markets, a country’s private

Savings/Investment in a Closed Economy Without access to world capital markets, a country’s private saving is the sole source of funds. Therefore, the domestic interest rate must adjust to insure that S = I + (G-T) n In this example, the domestic interest rate is equal to 10% and S = I +(GT) = 300 n What will happen if we expose this country to trade? n

Savings in the Open Economy n In an open economy, the rest of the

Savings in the Open Economy n In an open economy, the rest of the world becomes an added source of demand/supply of marketable securities S = I + (G-T) + NX Further, perfect capital mobility insures that all countries have the same (risk adjusted) real interest rate.

Savings in the Open Economy n Again, a trade deficit implies NX<0 n Therefore,

Savings in the Open Economy n Again, a trade deficit implies NX<0 n Therefore, S – (I – (G-T)) = NX < 0

Savings in the Open Economy n Again, a trade deficit implies NX<0 n Therefore,

Savings in the Open Economy n Again, a trade deficit implies NX<0 n Therefore, S – (I – (G-T)) = NX < 0 n A country with a trade deficit is borrowing from the rest of the world n That is, domestic supply of marketable securities is greater than domestic demand

Adding Net Exports to Capital Markets n Suppose that the prevailing world (real) interest

Adding Net Exports to Capital Markets n Suppose that the prevailing world (real) interest rate is 6%

Adding Net Exports to Capital Markets Suppose that the prevailing world (real) interest rate

Adding Net Exports to Capital Markets Suppose that the prevailing world (real) interest rate is 6% n At 6%, n S = $100 n I + (G-T) = $500 n NX = $100 - $500 = $400 n

Adding Net Exports to Capital Markets n Suppose that the prevailing world (real) interest

Adding Net Exports to Capital Markets n Suppose that the prevailing world (real) interest rate is 14%

Adding Net Exports to Capital Markets n Suppose that the prevailing world (real) interest

Adding Net Exports to Capital Markets n Suppose that the prevailing world (real) interest rate is 14% n S = $500 n I + (G-T) = $100 n NX = $500 - $100 = $400

Where does the world interest rate come from? Aggregate world savings is the sum

Where does the world interest rate come from? Aggregate world savings is the sum of private savings across countries n Aggregate Private Investment and Government Deficits are also summed over all countries n By definition, NX summed over all countries must equal zero. Therefore, at the real world equilibrium interest rate, S = I + (G-T) n In this example, r = 11% n

Example: An increase in productivity n Suppose that trade is initially balanced. A rise

Example: An increase in productivity n Suppose that trade is initially balanced. A rise in productivity increases investment demand

Example: An increase in productivity Suppose that trade is initially balanced. A rise in

Example: An increase in productivity Suppose that trade is initially balanced. A rise in productivity increases investment demand n In a closed economy, interest rates would rise n

Example: An increase in productivity Suppose that trade is initially balanced. A rise in

Example: An increase in productivity Suppose that trade is initially balanced. A rise in productivity increases investment demand n In a closed economy, interest rates would rise n In an open economy, the trade deficit would increase. In the case, the deficit increases from zero to $15, 000 n Do interest rates rise at all? n

World Capital Markets A country’s ability to influence world interest rates depends on its

World Capital Markets A country’s ability to influence world interest rates depends on its size relative to the world economy (recall, global interest rates are determined such that global capital markets clear) n The US makes up roughly 35% of the global economy. Therefore, the US can significantly influence global interest rates (as can Japan, EU, and China) n The rest of the world has little influence unless it acts as a unified group (Latin American Financial Crisis, Asian Crisis) n

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location n For example, suppose that the price of a television is $200 in the US and E 190 in Europe. The current exchange rate is $1. 17/E n

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location n For example, suppose that the price of a television is $200 in the US and E 190 in Europe. The current exchange rate is $1. 17/E n P* = E 190 (E Price in Europe)

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location n For example, suppose that the price of a television is $200 in the US and E 190 in Europe. The current exchange rate is $1. 17/E n What should happen here? n P* = E 190 (E Price in Europe) e. P* = ($1. 17/E)(E 190) = $222. 30

Exchange Rates and Price Levels n n The Law of One Price (LOOP) states

Exchange Rates and Price Levels n n The Law of One Price (LOOP) states that the same product should cost the same in every location For example, suppose that the price of a television is $200 in the US and E 190 in Europe. The current exchange rate is $1. 17/E What should happen here? A profit can be made by buying TVs in the US and selling them in Europe. P* = E 190 (E Price in Europe) e. P* = ($1. 17/E)(E 190) = $222. 30

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location n LOOP states that in equilibrium, no such profits can occur. Therefore, P = e. P* n

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location n LOOP states that in equilibrium, no such profits can occur. Therefore, P = e. P* n If the price of a TV is $200 in the US and E 190 in Europe, the implied exchange rate is $1. 05/E n

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location n LOOP states that in equilibrium, no such profits can occur. Therefore, P = e. P* n If the price of a TV is $200 in the US and E 190 in Europe, the implied exchange rate is $1. 05/E n P = $200 P* = E 190 P = e. P*

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the

Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location n LOOP states that in equilibrium, no such profits can occur. Therefore, P = e. P* n If the price of a TV is $200 in the US and E 190 in Europe, the implied exchange rate is $1. 05/E n P = $200 P* = E 190 P = e. P* e = P/P* = $200/E 190 = $1. 05/E

Purchasing Power Parity n Purchasing power parity (PPP) is simply LOOP applied to general

Purchasing Power Parity n Purchasing power parity (PPP) is simply LOOP applied to general price indices P = e. P*

Purchasing Power Parity n Purchasing power parity (PPP) is simply LOOP applied to general

Purchasing Power Parity n Purchasing power parity (PPP) is simply LOOP applied to general price indices P = e. P* n A more useful form of PPP is %Change in e = Inflation – Inflation*

Purchasing Power Parity n Purchasing power parity (PPP) is simply LOOP applied to general

Purchasing Power Parity n Purchasing power parity (PPP) is simply LOOP applied to general price indices P = e. P* n A more useful form of PPP is %Change in e = Inflation – Inflation* n For example, if the US inflation rate (annual) is 4% while the annual European inflation rate is 2%, the dollar should depreciate by 2% over the year.

PPP and the “Fundamentals” n Again, recall that PPP gives the following formula for

PPP and the “Fundamentals” n Again, recall that PPP gives the following formula for the nominal exchange rate: e = P/P*

PPP and the “Fundamentals” Again, recall that PPP gives the following formula for the

PPP and the “Fundamentals” Again, recall that PPP gives the following formula for the nominal exchange rate: e = P/P* n Further, the quantity theory give the price level as a function of money and output P = MV/Y n

PPP and the “Fundamentals” n n Again, recall that PPP gives the following formula

PPP and the “Fundamentals” n n Again, recall that PPP gives the following formula for the nominal exchange rate: e = P/P* Further, the quantity theory give the price level as a function of money and output P = MV/Y Combining the two, e = (V/V*)(M/M*)(Y*/Y) V, M, and Y are exchange rate “fundamentals”

PPP and the Real Exchange Rate n While the nominal exchange rate is defined

PPP and the Real Exchange Rate n While the nominal exchange rate is defined as the dollar price of foreign currency, the real exchange rate is defined as the price of foreign goods in terms of domestic goods q = e. P*/P

PPP and the Real Exchange Rate n While the nominal exchange rate is defined

PPP and the Real Exchange Rate n While the nominal exchange rate is defined as the dollar price of foreign currency, the real exchange rate is defined as the price of foreign goods in terms of domestic goods q = e. P*/P n PPP implies that the real exchange is always constant (actually, its equal to 1)

Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states

Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return n For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%, , the current exchange rate is $1. 15/E and the anticipated exchange rate in a year is $1. 10/E n

Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states

Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return n For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%, , the current exchange rate is $1. 15/E and the anticipated exchange rate in a year is $1. 10/E n n Each $1 invested in the US will be worth $1. 05 in a year. How about each $ invested in Europe?

Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states

Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return n For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%, , the current exchange rate is $1. 15/E and the anticipated exchange rate in a year is $1. 10/E n Each $1 invested in the US will be worth $1. 05 in a year. How about each $1 invested in Europe? n $1 = (1/1. 15) =. 87 E(1. 07) =. 93 E ($1. 10/E) = $1. 02 n

Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states

Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return n For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%, , the current exchange rate is $1. 15/E and the anticipated exchange rate in a year is $1. 10/E n Each $1 invested in the US will be worth $1. 05 in a year. How about each $1 invested in Europe? n $1 = (1/1. 15) =. 87 E(1. 07) =. 93 E ($1. 10/E) = $1. 02 n Even with the higher return in Europe, the 5% appreciation of the dollar makes the US asset a better investment. Therefore, funds will flow to the US. n

Interest Rate Parity n Interest parity states that exchange rates should be expected to

Interest Rate Parity n Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (1+i) = (1+i*)(e’/e)

Interest Rate Parity Interest parity states that exchange rates should be expected to adjust

Interest Rate Parity Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (1+i) = (1+i*)(e’/e) n A more useful form is i – i* = % change in e n For example, if the interest rate in the US is 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the Yen n

Interest Rate Parity n n Interest parity states that exchange rates should be expected

Interest Rate Parity n n Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (1+i) = (1+i*)(e’/e) A more useful form is i – i* = % change in e For example, if the interest rate in the US is 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the Yen Interest rate parity fails just as badly as PPP.

Interest Rate Parity & PPP n Recall that PPP gives the following: % change

Interest Rate Parity & PPP n Recall that PPP gives the following: % change in e = Inflation – Inflation*

Interest Rate Parity & PPP Recall that PPP gives the following: % change in

Interest Rate Parity & PPP Recall that PPP gives the following: % change in e = Inflation – Inflation* n Interest Parity gives the following: i – i* = % change in e n

Interest Rate Parity & PPP Recall that PPP gives the following: % change in

Interest Rate Parity & PPP Recall that PPP gives the following: % change in e = Inflation – Inflation* n Interest Parity gives the following: i – i* = % change in e n Combining them gives us i – i* = Inflation – Inflation* n

Interest Rate Parity & PPP Recall that PPP gives the following: % change in

Interest Rate Parity & PPP Recall that PPP gives the following: % change in e = Inflation – Inflation* n Interest Parity gives the following: i – i* = % change in e n Combining them gives us i – i* = Inflation – Inflation* i – Inflation = i* - Inflation* n

Interest Rate Parity & PPP Recall that PPP gives the following: % change in

Interest Rate Parity & PPP Recall that PPP gives the following: % change in e = Inflation – Inflation* n Interest Parity gives the following: i – i* = % change in e n Combining them gives us i – i* = Inflation – Inflation* i – Inflation = i* - Inflation* r = r* n

Summary of Classical Exchange Rate Theory n n Real interest differentials across countries are

Summary of Classical Exchange Rate Theory n n Real interest differentials across countries are zero. The trade balance is equal to S – (I + (G-T)) at the world interest rate Real exchange rates are constant Nominal Exchange rates are related to the “fundamentals” e = (V/V*)(M/M*)(Y*/Y) n There is no obvious correlation between trade balances, interest rates and exchange rates

Exchange Rates & the Fundamentals (JPY/USD)

Exchange Rates & the Fundamentals (JPY/USD)

Exchange Rates & the Fundamentals (GBP/USD)

Exchange Rates & the Fundamentals (GBP/USD)

Nominal/Real Exchange Rates

Nominal/Real Exchange Rates

Nominal/Real Exchange Rates

Nominal/Real Exchange Rates

Nominal/Real Exchange Rates

Nominal/Real Exchange Rates

Explaining Deviations from PPP n Transportation costs, tariffs, taxes, etc. interfere with LOOP n

Explaining Deviations from PPP n Transportation costs, tariffs, taxes, etc. interfere with LOOP n Non-Traded goods n Changes in Terms of Trade n Price indices are constructed differently n Fixed prices in the short run (Keynesian Economics)

Trading Costs: An Example n Suppose that the price of gold in Britain is

Trading Costs: An Example n Suppose that the price of gold in Britain is L 210 while the price of gold in the US is $300

Trading Costs: An Example Suppose that the price of gold in Britain is L

Trading Costs: An Example Suppose that the price of gold in Britain is L 210 while the price of gold in the US is $300 n The LOOP exchange rate (GBP/USD)will be equal to n e = P*/P = L 210 / $300 = L. 7/$

Trading Costs: An Example Suppose that the price of gold in Britain is L

Trading Costs: An Example Suppose that the price of gold in Britain is L 210 while the price of gold in the US is $300 n The LOOP exchange rate (USD/GBP) will be equal to n e = P/P* = $300 / L 210 = $1. 43/L n If the exchange rate deviates from. 1. 43, profits from arbitrage would be P – e. P* (Buy in GB, sell in US) e. P* - P (Buy in US, sell in GB)

Trading Costs: An Example Now, assume a $10 trading cost n Profits from arbitrage

Trading Costs: An Example Now, assume a $10 trading cost n Profits from arbitrage would now be n P – (e. P*+10) (Buy in GB, sell in US) e. P* - (P+10) (Buy in US, sell in GB)

Trading Costs: An Example Now, assume a $10 trading cost n Profits from arbitrage

Trading Costs: An Example Now, assume a $10 trading cost n Profits from arbitrage would now be n P – (e. P*+10) (Buy in GB, sell in US) e. P* - (P+10) (Buy in US, sell in GB) n Solving for the exchange rate gives us a range in which arbitrage is not profitable (P-10)/P* < e < (P+10)/P* 1. 38 < e < 1. 47

Trading Costs: An Example

Trading Costs: An Example

Non-Traded Goods: An Example n Suppose that in addition to gold, we add theatre

Non-Traded Goods: An Example n Suppose that in addition to gold, we add theatre tickets. Theatre tickets in the US cost $40 while in Britain, similar tickets cost L 30. Further, assume that the price index is defined (in both Britain and the US) as P =. 3(Tickets) +. 7(Gold)

Non-Traded Goods: An Example n Suppose that in addition to gold, we add theatre

Non-Traded Goods: An Example n Suppose that in addition to gold, we add theatre tickets. Theatre tickets in the US cost $40 while in Britain, similar tickets cost L 30. Further, assume that the price index is defined (in both Britain and the US) as P =. 3(Tickets) +. 7(Gold) CPI =. 3(40) +. 7(300) = $222 n CPI* =. 3(30) +. 7(210) = L 156 n

Non-Traded Goods: An Example CPI* =. 3(30) +. 7(210) = L 156 n CPI

Non-Traded Goods: An Example CPI* =. 3(30) +. 7(210) = L 156 n CPI =. 3(40) +. 7(300) = $222 n n Arbitrage will insure the nominal exchange rate will equal n E = P/P* = 300/210 = $1. 43/L

Non-Traded Goods: An Example CPI* =. 3(30) +. 7(210) = L 156 n CPI

Non-Traded Goods: An Example CPI* =. 3(30) +. 7(210) = L 156 n CPI =. 3(40) +. 7(300) = $222 n n Arbitrage will insure the nominal exchange rate will equal n n e = P/P* = 300/210 = $1. 43/L The real exchange rate equals n q = e(CPI*/CPI) = 1. 43(156/222) = 1

Non-Traded Goods: An Example n Suppose that the price of a theatre ticket in

Non-Traded Goods: An Example n Suppose that the price of a theatre ticket in the US increases to $50.

Non-Traded Goods: An Example Suppose that the price of a theatre ticket in the

Non-Traded Goods: An Example Suppose that the price of a theatre ticket in the US increases to $50. n CPI* =. 3(30) +. 7(210) = L 156 n CPI =. 3(50) +. 7(300) = $225 n

Non-Traded Goods: An Example Suppose that the price of a theatre ticket in the

Non-Traded Goods: An Example Suppose that the price of a theatre ticket in the US increases to $50. n CPI* =. 3(30) +. 7(210) = L 156 n CPI =. 3(50) +. 7(300) = $225 n n the nominal exchange rate stays at n e = P/P* = 300/210 = $1. 43/L

Non-Traded Goods: An Example Suppose that the price of a theatre ticket in the

Non-Traded Goods: An Example Suppose that the price of a theatre ticket in the US increases to $50. n CPI* =. 3(30) +. 7(210) = L 156 n CPI =. 3(50) +. 7(300) = $225 n n the nominal exchange rate stays at n n e = P/P* = 300/210 = $1. 43/L The real exchange rate equals n q = e(CPI*/CPI) = 1. 43(156/225) =. 991 (A real appreciation)

Relative Prices and Classical Economics n Classical theory begins with the real exchange rate

Relative Prices and Classical Economics n Classical theory begins with the real exchange rate (q)

Relative Prices and Classical Economics Classical theory begins with the real exchange rate (q)

Relative Prices and Classical Economics Classical theory begins with the real exchange rate (q) n Given movements of the real exchange rate, the nominal exchange rate evolves according to n e = q(Fundamentals) = q(V/V*)(M/M*)(Y*/Y) n

Example n The US dollar experienced a sharp appreciation during the eighties.

Example n The US dollar experienced a sharp appreciation during the eighties.

Example

Example

Example The US dollar experienced a sharp appreciation during the eighties. n This could

Example The US dollar experienced a sharp appreciation during the eighties. n This could be explained by an increase in the relative price of non-tradeables n n n Globalization lowered manufactured goods prices Falling equipment prices (computers) Rising cost of services (healthcare) This, however, can’t explain the decline in the dollar in the late eighties

Real exchange rates and real interest differentials n Recall n the interest parity condition

Real exchange rates and real interest differentials n Recall n the interest parity condition (i-i*) = %change in e n Subtracting inflation from both sides gives us a real interest parity condition n (r-r*) = %change in q

Relative Prices and the Trade Balance (r-r*) = %change in q n Therefore, a

Relative Prices and the Trade Balance (r-r*) = %change in q n Therefore, a real depreciation (an increase in q) forces a rise in domestic interest rates (to compensate for declining dollar values) n

Relative Prices and the Trade Balance n Higher interest rates increase domestic savings while

Relative Prices and the Trade Balance n Higher interest rates increase domestic savings while lowering domestic investment. This improves the trade balance

Classical Exchange Rate Theory and Relative Prices Real exchange rates are determined by relative

Classical Exchange Rate Theory and Relative Prices Real exchange rates are determined by relative price changes n Nominal Exchange rates are related to the real exchange rate plus the “fundamentals” n e = q (V/V*)(M/M*)(Y*/Y) Real interest differentials across countries are positively related to real exchange rate changes n Real depreciations (appreciations) will improve (worsen) the trade balances. n