Price Levels and the Exchange Rate in the Long Run. Chapter 16 International Economics Udayan Roy. Overview. Long-run analysis Real variables Nominal variables Flexible exchange rates We will study fixed exchange rates in Chapter 18. The Real Exchange Rate.
E$/€ is the nominal exchange rate, the price of one euro in dollars
PE is the overall price level in Europe, such as the consumer price index
PUS is the overall price level in the United States
q = 1
Equation (16-2) of the textbook, KOM9e
Equation (16-5) of the textbook, KOM9e
The crucial point to note about these expressions is that the variables on the right-hand sides of these equations are all exogenous. As exogenous variables are ‘mystery variables’ about which our theory has nothing to say, the equations on this slide say all that our theory can say about the endogenous variables on the left-hand sides of these equations.
Keep in mind that we are talking about the long run here. So, these equations show us the long run effects of permanent changes in the exogenous variables on the equations’ right-hand sides.
The first two variables are real variables: they can be measured even in barter (or, non-monetary) economies. The remaining variables are nominal variables: they make sense only on monetary economies.
Note that the money supply (Ms) has no effect on real variables. This is an instance of monetary neutrality in the long run.
Flashback to Ch. 15 of the textbook (KOM9e):
“A change in the supply of money has no effect on the long-run values of the interest rate or real output.” (p. 369)
“A permanent increase in the money supply causes a proportional increase
in the price level’s long-run value. In particular, if the economy is initially at full employment, a permanent increase in the money supply eventually will be followed by a proportional increase in the price level.” (p. 370)
The balance on a country’s current account (CA) is roughly its net exports
What does CA depend on in the long run?Bonus Topic: The Current Account