Chap 5
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The Price Level and Exchange Rate Chapter 5
What are we going to see in this chapter? • The « Law of one price » and the « Purchasing Power Parity » • Empirical results of those principles • The Balassa effect, tradeables and nontradeables • The real exchange rate and the competitiveness of an economy • If we have time: the monetary theory of exchange rates
1) The Law of One Price and the Purchasing Power Parity Definitions: • In principle, on a competitive market, and if one neglects transport costs, the prices of a given good should be equal in two countries (converted at the current market exchange rate): Pi = E x Pi* This is called « the Law of One Price » (LOP) • The Purchaing Power Parity (PPP) is a theory according to which the exchange rate between two currencies is equal to the ratio of the average prices of a the same basket of goods: E = P / P* This would be valid in the long run
More details on LOP and PPP • There is a difference between LOP and PPP: the first refers to a particular good whereas the second refers to a basket of goods and services, that is to the general price level. PPP may be true even is LOP is not. • PPP may be absolute or relative: it is absolute when it refers to the price levels; it is relative when it refers to the growth rate of prices • In the first case, we have E = P/P*; in the second, we have: ė = π – π* where ė = dLnE/dt and π are inflation rates = dLnP/dt
2) Empirical results on PPP • Is the PPP theory of exchange rates verified in reality? • All studies show that both theories (absolute and relative) are not verified. The LOP is rarely verified either. • The most well known example of non satisfactory test of the PPP theory is the so-called « Big Mac Index ». We will also try other tests.
The Big Mac Index • This test was invented by the journal «The Economist» in 1986. It consists in saying that a convenient «basket» of goods and services available in many countries is the famous Mac Donalds hamburger, which is everywhere in the world totally identical. • A Big Mac in China costs 10.5 yuan, and in four American cities it costs 3.10 dollars. Thus, the exchange rate of the yuan which makes the two prices equal should be 3.39 yuan to the dollar • However, the market rate of the yuan is circa 8 yuan to the dollar: consequently, the yuan is «undervalued» by 58% !
Some prices of the Big Mac in local currencies and in dollars •
The table below shows in column P the price of the Big Mac in local currency units, then this same price converted into dollars at the actual rate; the PPP is calculated dividing P by 3.10. The last column shows wether the local currency is over (+) or under (-) valued in relation to the dollar Country
USA
currency
Price P
Price in US$
PPP rate
Actual rate
Overvaluation
US Dollar
3.10
3.10
1
1
Australian $
3.25
2.44
1.05
1.33
-21
Britain
Pound
1.94
3.65
0.62
0.53
+18
China
Yuan
10.5
1.31
3.39
8.03
-58
Denmark
Danish Kroon
2.75
4.77
8.95
5.82
+54
Eurozone
Euro
2.94
3.77
0.95
0.78
+22
12
1.55
3.87
7.75
-50
Ringgit
5.50
1.52
1.77
3.63
-51
Singapore
Singapore $
3.60
2.27
1.16
1.59
-27
Switzerlan d Thailand
Swiss franc
6.30
5.21
2.03
1.21
+68
60
1.56
19.4
38.4
-50
Australia
Hong Kong Malaysia
Hong Kong $
Baht
0
Another test • We can also use the Penn World Tables to test the PPP theory • The PWT gives for all countries of the world a ratio of the country’s prices to the price level in the USA. This ratio may be compared to the market exchange rate of the country’s currency, either directly in levels, or in growth rates (relative PPP) • As an exercise, you will get these data from PWT for a sample of 50 countries and you will draw two graphs: one for the test of the absolute PPP in 2003, the other for the test of relative PPP over the period 1990-2003
The reasons why the PPP does not hold • There are still many barriers to trade goods over the world (whether tariffs or transport costs), and there are also natural barriers to trade services; as each sold good (including Big Mac) contains a service component … • There are still deviations to the competitive ideal world: products differenciation, market segmentation, allow LOP gaps • There are international differences in the measurement of prices (baskets differ etc) • But the most important is the « Balassa effect »
3) The Balassa – Samuelson effect • You may have remarked hat the PPP exchange rate is undervalued in most developing countries whereas it is overvalued in richer countries • This is related to the fact that in general, services in poor countries are cheaper than in rich countries • It is thus possible that, with a dollar income which is less in a poor country tan in a rich one, a qualified person may have a standard of living wich is much higher than his colleague in a rich country • This is the so-called Balassa-Samuelson effect. However, B-S go further and explain why it is so
The Balassa Samuelson conjecture • The question is : why is the price of non-tradeables higher in rich countries? • The answer relies in the productivity differential in the tradeables sector (B-S, 1964) • In the manufacturing sector, productivity is lower in poor countries, thus wages are lower • But wages in all sectors (incl. services) align themselves on the wages of the tradeable sector: if wages were higher in services, people would move away from manufacturing, labour supply in services would rise and wages there would decline. If they were lower, the inverse would take place. • There is thus an equalisation of wages in all sectors and the level of wages is determined by the productvity in the tradeables sector, despite the fact that productivity in services may be the same in all countries
Another explanation of the price differential in services • Put forward by J. Bhagwati in 1984 • Richer countries are more capitalistic than poor ones: the ratio K/L (capital output ratio) is lower in developing countries than in the developed world • Services are in general more labour intensive than manufacturing • So poor countries will « specialise » in services which correspond more to their factors endowment • Consequently, services in poor countries will appear cheaper than in rich countries
An important consequence of the Balassa-Samuelson effect • In many emerging countries, productivity in the manufacturing sector is low, but grows rapidly • This implies that wages in the tradeable sector also grow quickly in real terms • And, according to what we saw, wages in the service sector follow suit • As services use mainly labour, their prices will have to grow, so that they remain profitable • If prices of tradeables are determined by the world market – and are thus fixed if the exchange rate is stable –, prices of non tradeables will have to grow, generating inflation • Thus, emerging countries may be bound to a level of inflation higher than developed economies
4) The real exchange rate and the competitiveness of an economy • Accounting for the above restrictions, PPP remains valid as a long term determinant of the exchange rate. Economists use more frequently the notion of Real Exchange Rate (RER) in order to assess the competitivity of an economy • Definition: RER is a synthetic measure of goods and services prices of one country relative to others. It is calculated by dividing the nominal exchange rate by the (relative) price index • At odds with the PPP, the RER relies not on identical « baskets » of goods but on local indexes, calculated with differing baskets
The calculation of RER • As for PPP, there are two RER, absloute and relative. The first one is q = E x P*/P The second one is q^ = e^ + p*^ - p^ The first formula is used below to represent the evolution of the RER in Ukraine. P* = +0.2% per month Nominal exchange rate, price level and real exchange rate in Ukraine, 1996-2006 (monthly data) 600
STRONG DEPRECIATION OF THE HRYVNIA
160
300
140
200
120
100
100
Exchange rate
Consumer Price index
Real Exchange rate
pt -0 5 se
4 se pt -0
3 pt -0 se
2 pt -0 se
pt -0 1 se
pt -0 0 se
pt -9 9 se
pt -9 8 se
7
80 se pt -9
pt -9
6
0
Real exchange rate
180
400
se
Price index and nominal exchange rate
500
200
Use of the RER • The RER is a good indicator of the competitiveness of an economy. Or, better, of the evolution of this competitveness • If the RER rises, it is said that the currency depreciates in real terms, meaning that its prices become more attractve in international markets. This country becomes more competitive • If the RER declines, the currency appreciates in real terms and the country becomes less competitive • A country suffering inflation and with a fixed exchange rate becomes « richer » (in dollars) but is also losing its competitveness vis-à-vis the rest of the world
5) The monetary theory of exchange rates • We hane seen that the RER is q = E P*/P • But wat determines P*/P? • One theory is that the level of prices in a country depends on the quantity of money circulating in this country: the more money there is, the higher will be the prices • That idea relies on the theory of money demand
Money demand in a nutshell • Economic agents (households, firms etc) need money to do their transactions • But, as detaining money deprives them of gaining interests on better investments (detaining cash does not bring any interest at all), they will seek to hold as little money as possible • It has been shown that an economic agent will seek to hold an amount of « real money » which depends positively of their income and negatively of the interest rate on bonds • Md/P = L ( Y+, R-) where Md is the amount of money sought, P is the price level, R is the interest rate and Y is the income ; + and – are the signs of the derivative of L
The supply of money • Suppose now that money is emitted in a certain amount Ms decided by the central bank (that is true for cash) • Then, Md will have to adapt to Ms. But so doing, P, Y and R will have to adapt to the fixing of Ms ; • Y and R are real variables which depend on decisions of the economic agents independently of the money in circulation and of prices • Thus, we get P = Ms / L : the level of prices depends on the quantity of money in circulation
Test of that theory • You may process yourself a test of this theory: take a sample of countries in IMF data, and collect for each of them (a) the amount of money in circlation in 1970 and in 2000 and (b) the price level in the same years. Calculate from that the growth rate of both indicators between the two dates and plot the results on a graph. What form do you observe? • In general, when inflation is high, there is a very good fit between the amount of money in circulation and the price level. I represented it on the following graph for Ukraine
Relation between money supply and inflation: the case of Ukraine Hyperinflation et stabilisation en Ukraine 1992-1996
STABILISATION 10000
1000
100
10
AJUSTEMENT sur les PRIX RUSSES au PREMIER TRIMESTRE 1992 (PRIX MULTIPLIES par 6 en SYSTEME DES PRIX FIXES
LIBERATION DES PRIX
14% par mois
HYPERINFLATION 34% par
6% par mois
REDUCTION de la CROISSANCE de la MASSE MONETAIRE
24% par mois
1 se pt -9 1 dé c91 m ar s92 ju in -9 se 2 pt -9 2 dé c92 m ar s93 ju in -9 se 3 pt -9 3 dé c93 m ar s94 ju in -9 se 4 pt -9 4 dé c94 m ar s95 ju in -9 se 5 pt -9 5 dé c95 m ar s96 ju in -9 6
Indice des prix à la consommation, base 1 en 1990, Echelle logarithmique
100000
Indice des prix à la consommation
Billets en circulation
Back to exchange rates • Now, if we compare prices between countries (P*/P), there should be a good chance that this price ratio follows the ratio of the money masses. • If the money supply grows faster in a country, then its currency should depreciate (relative to a partner country) • But we should also take into account Y and R : if the output Y in a country grows faster, then its currency should appreciate; and if the interest rate rises in a country, its currency should depreciate
End of the lesson • Any question? • Dont forget you have two exercises to do in this chapter
What are we going to see in this chapter? • The « Law of one price » and the « Purchasing Power Parity » • Empirical results of those principles • The Balassa effect, tradeables and nontradeables • The real exchange rate and the competitiveness of an economy • If we have time: the monetary theory of exchange rates
1) The Law of One Price and the Purchasing Power Parity Definitions: • In principle, on a competitive market, and if one neglects transport costs, the prices of a given good should be equal in two countries (converted at the current market exchange rate): Pi = E x Pi* This is called « the Law of One Price » (LOP) • The Purchaing Power Parity (PPP) is a theory according to which the exchange rate between two currencies is equal to the ratio of the average prices of a the same basket of goods: E = P / P* This would be valid in the long run
More details on LOP and PPP • There is a difference between LOP and PPP: the first refers to a particular good whereas the second refers to a basket of goods and services, that is to the general price level. PPP may be true even is LOP is not. • PPP may be absolute or relative: it is absolute when it refers to the price levels; it is relative when it refers to the growth rate of prices • In the first case, we have E = P/P*; in the second, we have: ė = π – π* where ė = dLnE/dt and π are inflation rates = dLnP/dt
2) Empirical results on PPP • Is the PPP theory of exchange rates verified in reality? • All studies show that both theories (absolute and relative) are not verified. The LOP is rarely verified either. • The most well known example of non satisfactory test of the PPP theory is the so-called « Big Mac Index ». We will also try other tests.
The Big Mac Index • This test was invented by the journal «The Economist» in 1986. It consists in saying that a convenient «basket» of goods and services available in many countries is the famous Mac Donalds hamburger, which is everywhere in the world totally identical. • A Big Mac in China costs 10.5 yuan, and in four American cities it costs 3.10 dollars. Thus, the exchange rate of the yuan which makes the two prices equal should be 3.39 yuan to the dollar • However, the market rate of the yuan is circa 8 yuan to the dollar: consequently, the yuan is «undervalued» by 58% !
Some prices of the Big Mac in local currencies and in dollars •
The table below shows in column P the price of the Big Mac in local currency units, then this same price converted into dollars at the actual rate; the PPP is calculated dividing P by 3.10. The last column shows wether the local currency is over (+) or under (-) valued in relation to the dollar Country
USA
currency
Price P
Price in US$
PPP rate
Actual rate
Overvaluation
US Dollar
3.10
3.10
1
1
Australian $
3.25
2.44
1.05
1.33
-21
Britain
Pound
1.94
3.65
0.62
0.53
+18
China
Yuan
10.5
1.31
3.39
8.03
-58
Denmark
Danish Kroon
2.75
4.77
8.95
5.82
+54
Eurozone
Euro
2.94
3.77
0.95
0.78
+22
12
1.55
3.87
7.75
-50
Ringgit
5.50
1.52
1.77
3.63
-51
Singapore
Singapore $
3.60
2.27
1.16
1.59
-27
Switzerlan d Thailand
Swiss franc
6.30
5.21
2.03
1.21
+68
60
1.56
19.4
38.4
-50
Australia
Hong Kong Malaysia
Hong Kong $
Baht
0
Another test • We can also use the Penn World Tables to test the PPP theory • The PWT gives for all countries of the world a ratio of the country’s prices to the price level in the USA. This ratio may be compared to the market exchange rate of the country’s currency, either directly in levels, or in growth rates (relative PPP) • As an exercise, you will get these data from PWT for a sample of 50 countries and you will draw two graphs: one for the test of the absolute PPP in 2003, the other for the test of relative PPP over the period 1990-2003
The reasons why the PPP does not hold • There are still many barriers to trade goods over the world (whether tariffs or transport costs), and there are also natural barriers to trade services; as each sold good (including Big Mac) contains a service component … • There are still deviations to the competitive ideal world: products differenciation, market segmentation, allow LOP gaps • There are international differences in the measurement of prices (baskets differ etc) • But the most important is the « Balassa effect »
3) The Balassa – Samuelson effect • You may have remarked hat the PPP exchange rate is undervalued in most developing countries whereas it is overvalued in richer countries • This is related to the fact that in general, services in poor countries are cheaper than in rich countries • It is thus possible that, with a dollar income which is less in a poor country tan in a rich one, a qualified person may have a standard of living wich is much higher than his colleague in a rich country • This is the so-called Balassa-Samuelson effect. However, B-S go further and explain why it is so
The Balassa Samuelson conjecture • The question is : why is the price of non-tradeables higher in rich countries? • The answer relies in the productivity differential in the tradeables sector (B-S, 1964) • In the manufacturing sector, productivity is lower in poor countries, thus wages are lower • But wages in all sectors (incl. services) align themselves on the wages of the tradeable sector: if wages were higher in services, people would move away from manufacturing, labour supply in services would rise and wages there would decline. If they were lower, the inverse would take place. • There is thus an equalisation of wages in all sectors and the level of wages is determined by the productvity in the tradeables sector, despite the fact that productivity in services may be the same in all countries
Another explanation of the price differential in services • Put forward by J. Bhagwati in 1984 • Richer countries are more capitalistic than poor ones: the ratio K/L (capital output ratio) is lower in developing countries than in the developed world • Services are in general more labour intensive than manufacturing • So poor countries will « specialise » in services which correspond more to their factors endowment • Consequently, services in poor countries will appear cheaper than in rich countries
An important consequence of the Balassa-Samuelson effect • In many emerging countries, productivity in the manufacturing sector is low, but grows rapidly • This implies that wages in the tradeable sector also grow quickly in real terms • And, according to what we saw, wages in the service sector follow suit • As services use mainly labour, their prices will have to grow, so that they remain profitable • If prices of tradeables are determined by the world market – and are thus fixed if the exchange rate is stable –, prices of non tradeables will have to grow, generating inflation • Thus, emerging countries may be bound to a level of inflation higher than developed economies
4) The real exchange rate and the competitiveness of an economy • Accounting for the above restrictions, PPP remains valid as a long term determinant of the exchange rate. Economists use more frequently the notion of Real Exchange Rate (RER) in order to assess the competitivity of an economy • Definition: RER is a synthetic measure of goods and services prices of one country relative to others. It is calculated by dividing the nominal exchange rate by the (relative) price index • At odds with the PPP, the RER relies not on identical « baskets » of goods but on local indexes, calculated with differing baskets
The calculation of RER • As for PPP, there are two RER, absloute and relative. The first one is q = E x P*/P The second one is q^ = e^ + p*^ - p^ The first formula is used below to represent the evolution of the RER in Ukraine. P* = +0.2% per month Nominal exchange rate, price level and real exchange rate in Ukraine, 1996-2006 (monthly data) 600
STRONG DEPRECIATION OF THE HRYVNIA
160
300
140
200
120
100
100
Exchange rate
Consumer Price index
Real Exchange rate
pt -0 5 se
4 se pt -0
3 pt -0 se
2 pt -0 se
pt -0 1 se
pt -0 0 se
pt -9 9 se
pt -9 8 se
7
80 se pt -9
pt -9
6
0
Real exchange rate
180
400
se
Price index and nominal exchange rate
500
200
Use of the RER • The RER is a good indicator of the competitiveness of an economy. Or, better, of the evolution of this competitveness • If the RER rises, it is said that the currency depreciates in real terms, meaning that its prices become more attractve in international markets. This country becomes more competitive • If the RER declines, the currency appreciates in real terms and the country becomes less competitive • A country suffering inflation and with a fixed exchange rate becomes « richer » (in dollars) but is also losing its competitveness vis-à-vis the rest of the world
5) The monetary theory of exchange rates • We hane seen that the RER is q = E P*/P • But wat determines P*/P? • One theory is that the level of prices in a country depends on the quantity of money circulating in this country: the more money there is, the higher will be the prices • That idea relies on the theory of money demand
Money demand in a nutshell • Economic agents (households, firms etc) need money to do their transactions • But, as detaining money deprives them of gaining interests on better investments (detaining cash does not bring any interest at all), they will seek to hold as little money as possible • It has been shown that an economic agent will seek to hold an amount of « real money » which depends positively of their income and negatively of the interest rate on bonds • Md/P = L ( Y+, R-) where Md is the amount of money sought, P is the price level, R is the interest rate and Y is the income ; + and – are the signs of the derivative of L
The supply of money • Suppose now that money is emitted in a certain amount Ms decided by the central bank (that is true for cash) • Then, Md will have to adapt to Ms. But so doing, P, Y and R will have to adapt to the fixing of Ms ; • Y and R are real variables which depend on decisions of the economic agents independently of the money in circulation and of prices • Thus, we get P = Ms / L : the level of prices depends on the quantity of money in circulation
Test of that theory • You may process yourself a test of this theory: take a sample of countries in IMF data, and collect for each of them (a) the amount of money in circlation in 1970 and in 2000 and (b) the price level in the same years. Calculate from that the growth rate of both indicators between the two dates and plot the results on a graph. What form do you observe? • In general, when inflation is high, there is a very good fit between the amount of money in circulation and the price level. I represented it on the following graph for Ukraine
Relation between money supply and inflation: the case of Ukraine Hyperinflation et stabilisation en Ukraine 1992-1996
STABILISATION 10000
1000
100
10
AJUSTEMENT sur les PRIX RUSSES au PREMIER TRIMESTRE 1992 (PRIX MULTIPLIES par 6 en SYSTEME DES PRIX FIXES
LIBERATION DES PRIX
14% par mois
HYPERINFLATION 34% par
6% par mois
REDUCTION de la CROISSANCE de la MASSE MONETAIRE
24% par mois
1 se pt -9 1 dé c91 m ar s92 ju in -9 se 2 pt -9 2 dé c92 m ar s93 ju in -9 se 3 pt -9 3 dé c93 m ar s94 ju in -9 se 4 pt -9 4 dé c94 m ar s95 ju in -9 se 5 pt -9 5 dé c95 m ar s96 ju in -9 6
Indice des prix à la consommation, base 1 en 1990, Echelle logarithmique
100000
Indice des prix à la consommation
Billets en circulation
Back to exchange rates • Now, if we compare prices between countries (P*/P), there should be a good chance that this price ratio follows the ratio of the money masses. • If the money supply grows faster in a country, then its currency should depreciate (relative to a partner country) • But we should also take into account Y and R : if the output Y in a country grows faster, then its currency should appreciate; and if the interest rate rises in a country, its currency should depreciate
End of the lesson • Any question? • Dont forget you have two exercises to do in this chapter
