Prices and Exchange Rates

1 / 14

# Prices and Exchange Rates - PowerPoint PPT Presentation

Prices and Exchange Rates. Purchasing Power Parity. Purchasing Power Parity. Similar goods tend to sell for similar prices worldwide. Law of One Price

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.

## PowerPoint Slideshow about ' Prices and Exchange Rates' - libby-reynolds

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

### Prices and Exchange Rates

• Similar goods tend to sell for similar prices worldwide.
• Law of One Price

All goods must sell for the same price worldwide when converted into a common currency (if there is no transportation costs and no trade barriers).

That is E\$/¥= PUSi / PJi for all i,

where PUSi = price of good i in US

PJi = price of good i in Japan

• Absolute PPP

The equivalence of the exchange rate to the ratio of the foreign and domestic price levels

That is E\$/¥= PUS/ PJ

where PUS= price level of US

PJ= price level of Japan

price level = price of a reference commodity basket

• Relative PPP

The equivalence of the percentage change in the exchange rate to the inflation differential (the difference of the foreign and domestic changes in price levels).

That is ^E\$/¥= ^PUS - ^PJ

or ^E\$/¥= US - J

where ^()= % change in ()

US= inflation rate in US

J= inflation rate in Japan

• The law of one price implies but is not implied by PPP.
• Absolute PPP implies but is not implied by Relative PPP.
“Overvalued” and “Undervalued” Currencies
• “Overvalued”currency: Currency worth more than PPP value
• “Undervalued”currency: Currency worth less than PPP value
• In the early 1980s, may people said that dollar was overvalued.
Inflation and relative price changes
• Relative price changes  real shocks
• Inflation  nominal shocks
• Relative price movements are short run phenomena and tend to cancel out over time.
• In the long run, inflation dominates exchange rate movements.
• PPP holds better in the long run than in the short run.
Inflation and relative price changes
• PPP holds better for high-inflation countries.
• Even if law of one price holds perfectly for individual goods, PPP could be violated for a price index.
• Data does not give much empirical support to PPP.
Factors explaining the poor performance of PPP
• Trade restrictions and transport costs
• For some goods, transport costs are so large that they can never be traded internationally.  Nontraded goods (nontradables)
• Examples: construction (e.g. homebuilding), services (e.g. haircut), and domestic transportation (e.g. bus and train services).
• Exception: South Korean construction firms in Middle East in 70s and 80s.
• Local demand and supply determine their prices.
• 50% of US GNP is nontradables.
Factors explaining the poor performance of PPP
• Imperfectly competitive markets

Price discrimination: sells a commodity at different prices in different countries.

• Differences in price level measures

City

Man’s Haircut

Woman’s Cut

And Blow Dry

Country’s per

Capita Income 1988

Zurich

34.47

36.83

27,500

Tokyo

27.78

46.40

21,020

New York City

21.66

27.00

19,840

Frankfurt

13.64

20.20

18,480

Paris

23.87

36.81

16,090

London

17.32

28.60

12,810

Sydney

18.05

25.99

12,340

Hong Kong

14.06

18.75

9,220

Sao Paulo

7.33

15.95

2,160

Mexico City

6.50

9.94

1,760

Moscow

6.78

9.57

NA

Why haircuts prices are lower in poorer countries?
• Assume:
• Productivity in the tradables sector is higher in developed countries than in developing countries.
• Productivity in the nontradables sector is similar in both groups.
• Prices of tradables are the same in both groups.
Why haircuts prices are lower in poorer countries?
• Then: in developing countries
•  lower productivity in tradables
•  lower wage relative to developed countries
•  lower costs for nontradables
•  lower prices of nontradables
• Relative prices of nontradables will increase as real per capita income increases.