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
• Let us consider the price of an iPod in US and
Europe:
– In US, it is PUS = $200
– In Europe, it is PE = €150
– The value of the euro is E = 2 dollars per euro
– So, Europe's price in dollars is E × PE = $300
– So, each iPod in Europe costs as much as 1.5 iPods
in US
– E × PE / PUS = 1.5
– This is the Real dollar/euro Exchange Rate for
iPods
The Real Exchange Rate
• In general, the real exchange
rate is a broad summary
measure of the prices of one
country’s goods and services
relative to the other's.
– The real dollar/euro exchange
rate is the number of US
reference commodity
baskets—not just iPods—that
one European reference
commodity basket is worth:
– Equation (16-6)
E$ /  PE
q$ / 
PUS
The Real Exchange Rate
• Example: If the European reference
commodity basket costs €100, the U.S. basket
costs $120, and the nominal exchange rate is
$1.20 per euro, then the real dollar/euro
exchange rate (q$/€) is 1 U.S. basket per
European basket.
Real Depreciation and Appreciation
• Real depreciation of the dollar against the euro
– A rise in the real dollar/euro exchange rate (q$/€↑)
• is a fall in the purchasing power of a dollar within Europe’s borders
relative to its purchasing power within the United States
• Or alternatively, a fall in the purchasing power of America’s
products in general over Europe’s.
• Real appreciation of the dollar against the euro is
the opposite of a real depreciation: a fall in q$/€.
Absolute PPP
• A very simple theory of the real exchange rate
is called Absolute Purchasing Power Parity
• It says that:
q=1
• Why?
Law of One Price
• Going back for a second to the iPod example,
one can argue that PUS, the dollar price in the
US, ought to be equal to E × PE, the dollar
price in Europe. That is,
• E × PE = PUS.
• In general, E$/€ x PE = PUS.
• Therefore, q$/€ = (E$/€ x PE)/PUS = 1.
• This is the Law of One Price or Absolute
Purchasing Power Parity.
Prices and the Exchange Rate
Prices and the Exchange Rate
The Interest Rate
The Interest Rate
The Interest Rate: Fisher Effect
The Interest Rate
The Interest Rate
Output
• The real GDP produced when all resources are
fully utilized is known by various names:
– Long-run GDP
– Natural GDP
– Full-employment GDP
– Potential GDP (Yp)
• It is assumed in long-run analysis that the
economy makes full use of all its resources
• Therefore, in long-run equilibrium, Y = Yp.
Inflation
Inflation
Inflation
The Interest Rate, again
The Price Level
Appreciation Rate of the Foreign
Currency
The Exchange Rate: APPP version
Summary: Long-Run, Flexible Exchange
Rates
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.
Absolute PPP: logical but not factual
• Despite the logical appeal of Absolute
Purchasing Power Parity, available data
suggests that it is not true
• We need to look for another theory of the real
exchange rate, q.
Law of One Price for Hamburgers?
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
The Current Account
The Current Account
The Current Account
Y
CA
Yp
+
+
T
0
+
I, G
0
−
The Long Run
• The macroeconomic analysis of the long
run is characterized by the concept of
monetary neutrality
• That is, monetary arrangements and
monetary policy have no effect on the
behavior of real variables
• Therefore, the predictions summarized by
the table on this and the previous slide are
true for both the flexible exchange rate
system of this chapter and the fixed
exchange rate system of chapter 18
Y
CA
Yp
+
+
T
0
+
I, G
0
−