Understanding the Real Exchange Rate and Purchasing Power Parity, Slides of Economics

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Price Levels and the Exchange

Rate in the Long Run

Overview

• Long-run analysis
  • Real variables
  • Nominal variables
• Flexible exchange rates
  • We will study fixed exchange rates in chapter 18

The Real Exchange Rate

• In general, the real exchange rate is a broad summary measure of the prices of one country’s goods and services relative to the other's. - The real dollar/euro exchange rate is the number of US reference commodity baskets—not just iPods—that one European reference commodity basket is worth: - Equation (16-6)

US

E

P

E P

q

 

$ / $/

The Real Exchange Rate

• Example: If the European reference commodity basket costs €100, the U.S. basket costs $120, and the nominal exchange rate is $1.20 per euro, then the real dollar/euro exchange rate ( q $/€) is 1 U.S. basket per European basket.

Absolute PPP

• A very simple theory of the real exchange rate is called Absolute Purchasing Power Parity
• It says that:

q = 1

• Why?

Law of One Price

• Going back for a second to the iPod example, one can argue that P US, the dollar price in the US, ought to be equal to E × P E, the dollar price in Europe. That is,
• E × P E = P US.
• In general, E $/€ x P E = P US.
• Therefore, q $/€ = ( E $/€ x P E)/ P US = 1.
• This is the Law of One Price or Absolute Purchasing Power Parity.

Prices and the Exchange Rate

The Interest Rate

The Interest Rate: Fisher Effect

The Interest Rate

Output

• The real GDP produced when all resources are fully utilized is known by various names: - Long-run GDP - Natural GDP - Full-employment GDP - Potential GDP ( Y p)
• It is assumed in long-run analysis that the economy makes full use of all its resources
• Therefore, in long-run equilibrium, Y = Y p.

Inflation

Inflation

The Interest Rate, again