Chapter 3
Price Levels and Exchange Rate in the
Long Run
1-1
Preview
 Explain the purchasing power parity (PPP) theory
and its implications for exchange rate changes
 Explain the International Fisher effect (IFE) theory
and its implications for exchange rate changes
 Compare the PPP theory, the IFE theory, and the
theory of interest rate parity (IRP), which was
introduced in the previous chapter
Law of One Price
• The law of one price simply says that the same good in
different competitive markets must sell for the same price,
when transportation costs and barriers between those
markets are not important.
– Why? Suppose the price of pizza at one restaurant is
$20, while the price of the same pizza at an identical
restaurant across the street is $40.
– What do you predict will happen? Many people will
buy the $20 pizza, few will buy the $40 one.
Law of One Price
– Due to the price difference, entrepreneurs would have an
incentive to buy pizza at the cheap location and sell it at
the expensive location for an easy profit.
– Due to strong demand and decreased supply, the price of
the $20 pizza would tend to increase.
– Due to weak demand and increased supply, the price of
the $40 pizza would tend to decrease.
– People would have an incentive to adjust their behavior
and prices would tend to adjust until one price is
achieved across markets (across restaurants).
Law of One Price
• Consider a pizza restaurant in Seattle and one across the border
in Vancouver.
• The law of one price says that the price of the same pizza (using
a common currency to measure the price) in the two cities must
be the same if markets are competitive and transportation costs
and barriers between markets are not important.
PpizzaUS = (EUS$/C$) x (PpizzaCanada)
PpizzaUS = price of pizza in Seattle
PpizzaCanada = price of pizza in Vancouver
EUS$/C$ = U.S. dollar/Canadian dollar exchange rate
Purchasing Power Parity
• Purchasing power parity is the application of the law
of one price across countries for all goods and services,
or for representative groups (“baskets”) of goods and
services.
PUS = (EUS$/C$) x (PCanada)
PUS = level of average prices in the U.S.
PCanada = level of average prices in Canada
EUS$/C$ = U.S. dollar/Canadian dollar exchange rate
Purchasing Power Parity (cont.)
• Purchasing power parity (PPP) implies that the exchange
rate is determined by levels of average prices
EUS$/C$ = PUS/PCanada
– If the price level in the U.S. is US$200 per basket,
while the price level in Canada is C$400 per basket,
PPP implies that the C$/US$ exchange rate should be
C$400/US$200 = C$2/US$1.
– Predicts that people in all countries have the same
purchasing power with their currencies: 2 Canadian
dollars buy the same amount of goods as 1 U.S. dollar,
since prices in Canada are twice as high.
Purchasing Power Parity (cont.)
Purchasing power parity (PPP) comes in 2 forms:
• Absolute PPP: purchasing power parity that has
already been discussed. Exchange rates equal the level
of relative average prices across countries.
E$/€ = PUS/PEU
Purchasing Power Parity (cont.)
Relative PPP:
[1] Due to market imperfections, the prices of goods in all
countries will not necessarily be the same, but the rate of
change in prices should be equal when measured in
common currency.
[2] Relative purchasing power parity states that the
expected appreciation and depreciation of the spot rate is
determined by the expected inflation differential.
If
country X suffers a high rate of inflation than country Y
(the decline in purchasing power), then the value of X’s
currency will decline relative to the value of Y’s currency.
Purchasing Power Parity (cont.)
x / y
S
S

o
x/ y
t

E[S
S
P
P
P
P
o
y
Purchasing power parity at time = 0
o
x
t
y

x
(1  I ) Because Pt = Po(1+I) where, I is inflation rate
y
(
1

I
)
o
o
y
x
]
x/ y
x
P
P
t
x/ y
t
x

o
(1  I )
(1  I y )
Expected change in spot exchange rates = Expected inflation differential
e
x/ y

ex/ y
E[S
x/ y
t
S
] S x/ y
x/ y
o
x

(1  I )
1
y
(1  I )
Is percentage change in the spot exchange rate
Purchasing Power Parity (cont.)
Shortcomings of PPP
• There is little empirical support for absolute
purchasing power parity.
– The prices of identical commodity baskets, when
converted to a single currency, differ substantially
across countries.
• Relative PPP is more consistent with data, but it also
performs poorly to predict exchange rates.
The Yen/Dollar Exchange Rate and Relative Japan-U.S. Price
Levels, 1980–2012
Shortcomings of PPP
Why Purchasing Power Parity Does Not Hold
 Confounding effects
 A change in a country’s spot rate is driven by more than the
inflation differential between two countries:
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Shortcomings of PPP
• Trade barriers and nontradable products
– Transport costs and governmental trade restrictions
make trade expensive and in some cases create
nontradable goods or services.
– Services are often not tradable: services are generally
offered within a limited geographic region (for example,
haircuts).
– The greater the transport costs, the greater the range
over which the exchange rate can deviate from its PPP
value.
– One price need not hold in two markets.
Shortcomings of PPP
• Imperfect competition may result in price
discrimination: “pricing to market.”
– A firm sells the same product for different prices in
different markets to maximize profits, based on
expectations about what consumers are willing to
pay.
– One price need not hold in two markets.
Shortcomings of PPP
• Differences in the measure of average prices for
goods and services
– levels of average prices differ across countries
because of differences in how representative
groups ( “ baskets ” ) of goods and services are
measured.
– Because measures of groups of goods and services
are different, the measure of their average prices
need not be the same.
– One price need not hold in two markets.
Law of One Price for
Hamburgers?
International Fisher Effect (IFE)
Fisher Effect:
(1+i) = (1+r)(1+I) where: i: nominal interest rate; r: real interest rate; I: inflation rate
Fisher Effect:
Relative PPP:
1 i
1 i
X
Y
E [S
S

(1  r
(1  r
USD
t
USD
X
/ VND
/ VND
Y
I
)( 1  I
)( 1 
]

o
X
Y
)

)
(1 
(1 
I
I
I
(1  I
(1 
VND
USD
X
)
Y
)
)
)
International Fisher Effect:
E [S
S
USD
t
USD
o
/ VND
/ VND
]

1 i
1 i
VND
USD
19
International Fisher Effect (IFE)
Using the IFE to Predict Exchange Rate Movements
 Apply the Fisher Effect to Derive Expected Inflation per Country
 The first step is to derive the expected inflation rates of the
two countries based on the Fisher effect. The Fisher effect
suggests that nominal interest rates of two countries differ
because of the difference in expected inflation between the
two countries.
 Rely on PPP to Estimate the Exchange Rate Movement
 The second step of the international Fisher effect is to apply
the theory of PPP to determine how the exchange rate would
change in response to those expected inflation rates of the two
countries.
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International Fisher Effect (IFE)
Implications of the International Fisher Effect
 The international Fisher effect (IFE) theory suggests that
currencies with high interest rates will have high expected
inflation (due to the Fisher effect) and the relatively high
inflation will cause the currencies to depreciate (due to the
PPP effect).
 Implications of the IFE for Foreign Investors
 The implications are similar for foreign investors who
attempt to capitalize on relatively high U.S. interest rates.
The foreign investors will be adversely affected by the
effects of a relatively high U.S. inflation rate if they try to
capitalize on the high U.S. interest rates.
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International Fisher Effect (IFE)
22
Comparison of the IRP, PPP, and IFE
Although all three theories relate to the determination of exchange
rates, they have different implications. (Exhibit 8.9)
 IRP focuses on why the forward rate differs from the spot rate
and on the degree of difference that should exist. It relates to a
specific point in time.
 PPP and IFE focus on how a currency’s spot rate will change
over time.
 Whereas PPP suggests that the spot rate will change in
accordance with inflation differentials, IFE suggests that it will
change in accordance with interest rate differentials.
 PPP is related to IFE because expected inflation differentials
influence the nominal interest rate differentials between two
countries.
23
Comparison of the IRP, PPP, and IFE Theories
24
SUMMARY
 Purchasing power parity (PPP) theory specifies a
precise relationship between the relative inflation
rates of two countries and their exchange rate. PPP
theory suggests that the equilibrium exchange rate
will adjust by about the same magnitude as the
difference between the two countries’ inflation rates.
Although PPP continues to be a valuable concept,
there is evidence of sizable real-world deviations
from the theory.
25
SUMMARY
 The international Fisher effect (IFE) specifies a
precise relationship between relative interest rates of
two countries and their exchange rates. It suggests
that an investor who periodically invests in interestbearing foreign securities will, on average, achieve a
return similar to what is possible domestically. This
implies that the exchange rate of the country with
high interest rates will depreciate to offset the interest
rate advantage achieved by foreign investments.
26
SUMMARY
• The PPP theory focuses on the relationship between
the inflation rate differential and future exchange
rate movements. The IFE focuses on the interest
rate differential and future exchange rate
movements. These theories explain how exchange
rates move over time, while interest rate parity
(IRP) theory covered in the previous chapter
focuses on the relationship between the interest rate
differential and the forward rate premium (or
discount) at a given point in time.
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