Exchange Rates and Purchasing Power Parity CHAPTER 13

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

Introduction Exchange rates matter in many different ways to many different constituencies in the world economy n Much of this section on international finance will be directly or indirectly concerned with exchange rates n Reinert/Windows on the World Economy, 2005 2

The Nominal Exchange Rate n Relative price of two currencies § Often expressed as number of units of local or home currency required to buy a unit of foreign currency n n 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 Reinert/Windows on the World Economy, 2005 3

Table 13. 1. Nominal Exchange Rates, October 9, 2002 (per US dollar) Reinert/Windows on the World Economy, 2005 4

Figure 13. 1. The Value of the Peso Scale Reinert/Windows on the World Economy, 2005 5

The Real Exchange Rate Measures the rate at which two countries’ goods trade against each other n Makes use of the price levels in the two countries under consideration n § PM—overall price level in Mexico (the home country) § PUS—overall price level in the United States (the foreign country) Reinert/Windows on the World Economy, 2005 6

Table 13. 2. Changes in the Real Exchange Rate Reinert/Windows on the World Economy, 2005 7

The Real Exchange Rate n n n 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 n § Real exchange rates affected by both nominal exchange rates and price levels Reinert/Windows on the World Economy, 2005 8

Exchange Rates and Trade Flows n n 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 • is in dollar terms ¨ Multiplying it by e gives us Reinert/Windows on the World Economy, 2005 in peso terms 9

Exchange Rates and Trade Flows n 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 n § 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 Reinert/Windows on the World Economy, 2005 10

Figure 13. 2. The Value of the Peso and Mexico’s Imports Reinert/Windows on the World Economy, 2005 11

Figure 13. 3. The Value of the Peso and Mexico’s Exports Reinert/Windows on the World Economy, 2005 12

Exchange Rates and Trade Flows n Relationship between the peso and dollar prices of Mexico’s exported (E) goods can be expressed as n 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 Reinert/Windows on the World Economy, 2005 13

Exchange Rates and Trade Flows n 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 n 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 Reinert/Windows on the World Economy, 2005 14

Figure 13. 4. The Value of the Peso and Mexico’s Trade Deficit Reinert/Windows on the World Economy, 2005 15

The Purchasing Power Parity Model n n 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 Reinert/Windows on the World Economy, 2005 16

PPP Equation n PPP hypothesis is § Invert the equation § Divide both sides of the above equation by PUS to obtain PPP equation Reinert/Windows on the World Economy, 2005 17

Meaning of PPP Equation n 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 n 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 n Nominal value of the peso adjusts to changes in its real purchasing power in the two countries Reinert/Windows on the World Economy, 2005 18

Meaning of PPP Equation n Restrictiveness of PPP model can be seen when we re-express it in a third equation § Multiplying both sides of the PPP equation by § Obtain modified PPP equation § Compare this equation with real exchange rate Reinert/Windows on the World Economy, 2005 19

PPP Model as Special Case n 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 Reinert/Windows on the World Economy, 2005 20

PPP Model as Special Case n Real exchange rate equation captures reality at any point in time § PPP relationship never holds exactly n PPP equation gives a sense of a long-term tendency towards which nominal exchange rates move absent other changes Reinert/Windows on the World Economy, 2005 21

Exchange Rate Exposure n n n 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 Reinert/Windows on the World Economy, 2005 22

Forward Markets n 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 n n 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 23