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Exchange Rates and Purchasing Power Parity (PPP)

Exchange rates are crucial in international trade and competitiveness, reflecting the value of one currency relative to another. The concept of Purchasing Power Parity (PPP) helps explain how exchange rates are determined in the long run based on the relative price levels of different countries.

The Impact of Exchange Rates on Competitiveness

The exchange rate (ER) is the price of one currency in terms of another. Fluctuations in exchange rates significantly impact a country's economic competitiveness and daily life.

• In the mid-1980s, American businesses became less competitive. The U.S. dollar was strong, meaning it was worth more in foreign currencies. This made American goods more expensive for foreigners and foreign goods cheaper for Americans.

• During the 1990s and 2000s, the value of the U.S. dollar fell, making American goods cheaper and American businesses more competitive. Conversely, foreign goods became more expensive for Americans.

Currency Exchange Mechanisms

Most countries have their own currency (e.g., U.S. dollar, Euro, Brazilian real, Indian rupee). International trade necessitates the exchange of these currencies, typically through bank deposits.

• When an American firm purchases foreign goods, services, or financial assets, U.S. dollars must be exchanged for the foreign currency in the Foreign Exchange Market (FOREX).

• Spot transactions involve the immediate (two-day) exchange of bank deposits at the spot exchange rate (spot ER).

• Forward transactions involve the exchange of bank deposits at a specified future date at the forward exchange rate (forward ER).

Calculating Currency Appreciation and Depreciation

Currency movements can be quantified to understand appreciation or depreciation. A rise in the plot of a foreign currency against a domestic currency indicates the foreign currency's strengthening (domestic currency's weakening).

1. Euro Depreciation Example:

   • Beginning 1999: 1.18" data-type="inline-math"></span></p></li><li><p style="text-align: left;">February 5, 2003: <span data-latex="\euro 1 = \1.08" data-type="inline-math">

   • Calculation for Euro depreciation:

   • The Euro depreciated by approximately 8%.

2. Dollar Appreciation Example:

   • Beginning 1999: 1 = \euro 0.85" data-type="inline-math"></span></p></li><li><p style="text-align: left;">February 2003: <span data-latex="\1 = \euro 0.93" data-type="inline-math">

   • Calculation for Dollar appreciation:

   • The Dollar appreciated by approximately 9%.

Exchange Rates and Relative Prices

Exchange rates directly influence the relative prices of domestic and foreign goods. The dollar price of a foreign good depends on two factors:

1. The price of the foreign good in its local currency.

2. The exchange rate between the foreign currency and the dollar.

Example: Buying French Wine

• Initially: A bottle of wine costs . The exchange rate is 1.08 = \euro 1" data-type="inline-math"></span>.</p><ul class="tight" data-tight="true"><li><p style="text-align: left;">Dollar cost: <span data-latex="1,000 \, \text{euros} \times \1.08/\text{euro} = \1,080" data-type="inline-math"></span>.</p></li></ul></li><li><p style="text-align: left;">After 2 months: The euro appreciates to <span data-latex="\1.20 = \euro 1" data-type="inline-math">. The domestic price remains .

  • New dollar cost: 1.20/\text{euro} = \1,200" data-type="inline-math">.

This shows that an appreciation of the foreign currency makes foreign goods more expensive for domestic consumers.

Law of One Price

The law of one price posits that for an identical good in two countries, with low transportation costs and trade barriers, the price of the good should be the same worldwide, regardless of where it's produced.

Example: American vs. Japanese Steel

• American steel: per ton.

• Japanese steel: per ton.

• According to the law of one price, </p></li></ul><p style="text-align: left;"></p><p style="text-align: left;">P_{USA} = P_J<span data-latex=", so " data-type="inline-math"></span>\<span data-latex="100 = \yen 10,000" data-type="inline-math"></span>.</p><ul class="tight" data-tight="true"><li><p style="text-align: left;">This implies a nominal exchange rate where <span data-latex="\yen 1 = \0.01" data-type="inline-math"> or 1 = \yen 100" data-type="inline-math"></span>.</p></li></ul><p style="text-align: left;">If the price of American steel rises to <span data-latex="\200" data-type="inline-math"> per ton, then to maintain the law of one price, would equal $0.02" data-type="inline-math"></span>.</p><h3 style="text-align: left;">Purchasing Power Parity (PPP)</h3><p style="text-align: left;">The theory of <strong>Purchasing Power Parity (PPP)</strong> extends the law of one price to national price levels. It suggests that the exchange rate between two currencies will adjust to reflect changes in the relative price levels of the two countries.</p><p style="text-align: left;">The PPP exchange rate (using an indirect quotation for the price of foreign currency) is given by:</p><p style="text-align: left;"><span data-latex="e_{PPP} = \frac{P}{P^{*}}" data-type="inline-math"></span></p><p style="text-align: left;">Where:</p><ul class="tight" data-tight="true"><li><p style="text-align: left;"><span data-latex="e" data-type="inline-math"></span>: exchange rate (price of foreign currency in domestic currency, e.g., dollars per yen).</p></li><li><p style="text-align: left;"><span data-latex="P" data-type="inline-math"></span>: price level in the domestic country (e.g., USA).</p></li><li><p style="text-align: left;"><span data-latex="P^{*}" data-type="inline-math"></span>: price level in the foreign country (e.g., Japan).</p></li></ul><p style="text-align: left;">This implies that <span data-latex="eP^{*} = P" data-type="inline-math"></span>. If the domestic price level (<span data-latex="P" data-type="inline-math"></span>) increases while the foreign price level (<span data-latex="P^{*}" data-type="inline-math"></span>) remains constant, the exchange rate (<span data-latex="e" data-type="inline-math"></span>) must increase, meaning the foreign currency becomes more expensive (or the domestic currency depreciates).</p><p style="text-align: left;">Key Implications of PPP</p><ul class="tight" data-tight="true"><li><p style="text-align: left;">If one country's price level rises relative to another's, its currency should depreciate.</p></li><li><p style="text-align: left;"><strong>Inflation leads to depreciation</strong>: An increase in a country's domestic price level (<span data-latex="P" data-type="inline-math"></span>) relative to another country's (<span data-latex="P^{*}" data-type="inline-math"></span>) will cause the domestic currency to depreciate (<span data-latex="e" data-type="inline-math"></span> increases, meaning the price of the foreign currency in domestic terms rises).</p><blockquote><p style="text-align: left;">Example: If the American price level rises by 10$1,080" data-type="inline-math"> and . The initial exchange rate 1.08/\text{euro}" data-type="inline-math"></span>.</p><p style="text-align: left;">If there is inflation in Europe and <span data-latex="P^{*}" data-type="inline-math"></span> rises to <span data-latex="\euro 1,100" data-type="inline-math"></span>, for PPP to hold, the price of the euro (<span data-latex="e" data-type="inline-math"></span>) must decrease (euro must depreciate).</p><p style="text-align: left;"><span data-latex="e = \frac{P}{P^{*}} = \frac{\1,080}{\euro 1,100} = \0.98 \text{ per euro}" data-type="inline-math"></span>. This shows a depreciation of the euro from <span data-latex="\1.08" data-type="inline-math"> to per euro.

  Long-Run Validation of PPP

  Empirical evidence often supports PPP in the long run, but short-run deviations are common. For instance, between 1973 and 2002, the British price level rose by 99% relative to the U.S. price level. As predicted by PPP, the U.S. dollar appreciated against the British pound, though by 73%, which was less than the 99% adjustment predicted by the theory.

  Key Takeaways

  • Exchange rates determine the relative cost of goods between countries and impact national competitiveness.

  • Appreciation makes domestic goods more expensive for foreigners and foreign goods cheaper for domestic consumers.

  • Depreciation makes domestic goods cheaper for foreigners and foreign goods more expensive for domestic consumers.

  • The Law of One Price states that identical goods should have the same price globally, accounting for exchange rates.

  • Purchasing Power Parity (PPP) extends this concept to national price levels, predicting that exchange rates adjust to offset differences in inflation rates.

  • Inflation in a country typically leads to the depreciation of its currency relative to currencies of countries with lower inflation.