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Quick Review : A Simple Model of Long Run Exchange Rates

Quick Review : A Simple Model of Long Run Exchange Rates. Roberto Chang February 2012. Purchasing Power Parity. PPP is a long run relation between exchange rates and price levels Absolute PPP: P US = E $/€ *P EUR In changes  Relative PPP:

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Quick Review : A Simple Model of Long Run Exchange Rates

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  1. Quick Review: A Simple Model of Long Run Exchange Rates Roberto Chang February 2012

  2. PurchasingPowerParity • PPP is a longrunrelationbetweenexchangerates and pricelevels • Absolute PPP: PUS = E$/€ *PEUR • In changes Relative PPP: πUS = (∆ E$/€ / E$/€ ) + πEUR

  3. So… • Absolute PPP implies E$/€ = PUS /PEUR whilerelative PPP gives ∆ E$/€ / E$/€= πUS –πEUR ==> To derive predictionsfortheexchangerate, weneedtounderstandthedeterminants of pricelevels.

  4. A Simple Theory of the Price Level • Supply and Demandfor Money: MUS = MdUS = LPUSYUS So PUS = MUS /LYUS And πUS = µUS – gUS

  5. Long Run Exchange Rates • FromAbsolute PPP, now, E$/€ = PUS /PEUR = (MUS /LYUS)/(MEU/L* YEU ), or E$/€ = constant * (MUS/ MEU)/(YUS/ YEU) • In changes, ∆ E$/€ / E$/€ = πUS –πEUR = µUS – gUS - (µEU – gEU )

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