Price Levels and the Exchange Rate in the Long Run. Lecture Notes on Ch. 15 of Krugman and Obstfeld, 7 th Ed. Udayan Roy, December 2008. Purchasing Power Parity. The simplest theory of prices and exchange rates for the long run is (absolute) purchasing power parity. The Real Exchange Rate.
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Price Levels and the Exchange Rate in the Long Run
Lecture Notes on Ch. 15 of Krugman and Obstfeld, 7th Ed.
Udayan Roy, December 2008
q = 1
Current account
depends on the real
exchange rate and
disposable income.
Consumption
depends on
disposable
income
Investment and
government
purchases, both
exogenous
D = C(Y – T) + I + G + CA(q, Y – T)
D = D(q, Y – T, I, G)
Aggregate demand as a function of the
real exchange rate, disposable income,
investment, government purchases
Value of output,
income from
production
Y = D(q, Y – T, I, G)
Output is greater
than aggregate
demand: firms
decrease output
Aggregate
demand is
greater than
production:
firms increase
output
Y = D(q, Y – T, I, G)
Y = D(q, Y – T, I, G)
Aggregate Demand, D
45° line
Aggregate Demand (q2)
Aggregate Demand (q1)
Y2
Output, Y
Y1
Real Exchange Rate, q
DD Curve
q2
q1
Output, Y
Y2
Y1
Y = D(q, Y – T, I, G)
Real Exchange Rate, q
DD Curve
q2
q1
Output, Y
Yp = Y2
Yp = Y1
Aggregate Demand, D
45° line
Aggregate Demand2
Aggregate Demand1
Y2
Output, Y
Y1
Real Exchange Rate, q
DD1
DD2
q1
Output, Y
Y2
Y1
Y = D(q, Y – T, I, G)
Real Exchange Rate, q
DD1
DD2
q1
q2
Output, Y
Yp
Figure 15-2: Inflation and Interest Rates in Switzerland, the United States, and Italy, 1970-2000
Figure 15-2: Continued
Figure 15-2: Continued
Note that the effect of the domestic full-employment output on the exchange rate is ambiguous.
(a) U.S. money supply, MUS
(b) Dollar interest rate, R$
R$2 = R$1 +
Slope = +
MUS, t0
R$1
Slope =
t0
t0
Time
Time
(d) Dollar/euro exchange rate, E$/€
(c) U.S. price level, PUS
Slope = +
Slope = +
Slope =
Slope =
t0
Time
t0
Time
reUS – reE = (qe$/€–q$/€)/q$/€(15-10)
RUS – RE = (Ee$/€ – E$/€)/E$/€(13-2)
reUS – reE = (qe$/€ – q$/€)/q$/€(15-10)