Exchange Rates and
Purchasing Power Parity
CHAPTER 13
Reinert/Windows on the World Economy, 2005
Introduction
Exchange rates matter in many different
ways to many different constituencies in the
world economy
 Much of this section on international finance
will be directly or indirectly concerned with
exchange rates

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The Nominal Exchange Rate

Relative price of two currencies
 Often expressed as number of units of local or home currency
required to buy a unit of foreign currency


We will usually view Mexico (peso) as our home country and
United States (dollar) as our foreign country
Nominal or currency exchange rate (e) is
local currency
pesos
e

foreign currency dollar
 If e increases the value of the peso (home currency) falls
 If e decreases the value of the peso (home currency) rises
 e and the value of the peso are inversely related
• e is often graphed as its inverse which is equal to the value of the peso
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Table 13.1. Nominal Exchange Rates,
October 9, 2002 (per US dollar)
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Figure 13.1. The Value of the
Peso Scale
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The Real Exchange Rate
Measures the rate at which two countries’
goods trade against each other
 Makes use of the price levels in the two
countries under consideration
 PM—overall price level in Mexico (the home

country)
 PUS—overall price level in the United States (the
foreign country)
P US
re  e  M
P
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Table 13.2. Changes in the Real
Exchange Rate
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The Real Exchange Rate



Suppose that the price level in the United States rises
 Takes more Mexican goods to purchase US goods
 Represents a fall in the real value of the peso
Suppose that the price level in Mexico rises
 Takes fewer Mexican goods to purchase US goods
 Represents a rise in the real value of the peso
Suppose that the nominal exchange rate increases
 Takes more Mexican pesos to buy a US dollar and, therefore, more
Mexican goods to buy US goods
 Represents a fall in the real value of the peso

Real exchange rates affected by both nominal exchange
rates and price levels
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Exchange Rates and Trade
Flows


Changes in e have an impact on trade flows
Consider the case of Mexico’s imports and exports
 World prices (PW) are typically in US dollar terms
 Mexican prices (PM) are in peso terms
• Relationship between the peso and world prices of Mexico’s
import (Z) goods can be expressed as
PZM  e  PZW
•
PZW is in dollar terms
M
 Multiplying it by e gives us PZ in peso terms
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Exchange Rates and Trade
Flows

Suppose e were to increase (the value of the peso
falls)
 Movement down the scale in Figure 13.1 increases the
peso price of the imported good in Mexico
Import demand consequently decreases


Suppose e were to decrease (the value of the peso
rises)
 Movement up the scale in Figure 13.1 decreases the
peso price of the imported good in Mexico
 Import demand consequently increases
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Figure 13.2. The Value of the
Peso and Mexico’s Imports
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Figure 13.3. The Value of the
Peso and Mexico’s Exports
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Exchange Rates and Trade
Flows

Relationship between the peso and dollar prices of
Mexico’s exported (E) goods can be expressed as
PEM  e  PEW

Suppose e were to increase (the value of the peso
falls)
 Movement down the scale in Figure 13.1 increases the

peso price of the export good in Mexico
Export supply in Mexico consequently increases
• Mexican firms now have more of an incentive in peso terms to
export
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Exchange Rates and Trade
Flows

Suppose e were to decrease (the value of
the peso rises)
 Movement up the inverse scale in Figure 13.1
decreases the peso price of exports in Mexico
 Export supply consequently decreases

Can put the relationships of Figures 13.2 and
13.3 together
 Figure 13.4 represents the positive relationship
between value of peso and trade deficit, or Z – E
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Figure 13.4. The Value of the
Peso and Mexico’s Trade Deficit
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The Purchasing Power Parity
Model


Begins with the hypothesis that the nominal exchange rate will adjust so
that the purchasing power of a currency will be the same in every
country
Implications of hypothesis
 Purchasing power of a currency in a given country is inversely related to
price level in that country
• For example, purchasing power of the peso in Mexico can be expressed as
1 M
P

The higher the price level in Mexico the lower the purchasing power of the
peso
 Purchasing power of peso in United States is more complicated
• Need rate at which a peso can be exchanged into dollars, or 1/e
• Need purchasing power of a dollar in United States, or 1/PUS
• Purchasing power of a peso in United States is
1e  1P 
US
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PPP Equation

PPP hypothesis is
1
1
1


P M e P US
 Invert the equation
M
US
P  eP
 Divide both sides of the above equation by PUS
to obtain PPP equation
PM
e  US
P
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Meaning of PPP Equation

Suppose PM were to increase
 According to the PPP model, e would increase
• Value of the peso would move down the scale in
Figure 13.1

Suppose PUS were to increase
 According to the PPP model e would decrease
• Value of the peso would move up the scale in Figure
13.1

Nominal value of the peso adjusts to
changes in its real purchasing power in the
two countries
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Meaning of PPP Equation

Restrictiveness of PPP model can be seen when
we re-express it in a third equation
 Multiplying both sides of the PPP equation by

P US
M

P
 Obtain modified PPP equation
P US
e M 1
P
 Compare this equation with real exchange rate
P US
e M  re
P
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PPP Model as Special Case

PPP model is a special case of the real
exchange rate
 Implies that real exchange rate is fixed at unity
• No change in real exchange rate

However real exchange rates do change therefore there
must be important elements of the real world that the PPP
theory ignores
 PPP assumes all goods entering into the price levels of
both countries are internationally traded
 Phenomenon of product differentiation
 Allows for separate markets (and therefore prices) for
import and domestic varieties of a good
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PPP Model as Special Case
Real exchange rate equation captures reality
at any point in time
 PPP relationship never holds exactly
 PPP equation gives a sense of a long-term
tendency towards which nominal exchange
rates move absent other changes

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Exchange Rate Exposure



If sales from either exporting or foreign direct investment are
not denominated in the currencies of the firms’ home
countries
 Exchange rate exposure issues arise
Suppose that the €/US$ exchange rate is currently at a
value of 1.00
Suppose also that a US firm is expecting euro revenues of
€1.0 million
 Current exchange rate (spot rate) suggests US firm might be
expecting dollar revenues of US$1.0 million
 Suppose, however, that the spot rate moves to e = 1.25 (a dollar
value of the euro of $0.80)
• Now takes more euros to purchase a dollar—dollar revenues shrink to
$800,000
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Forward Markets

For some currencies forward rates also exist
 Rates of current contracts for “forward” transactions in currencies
• Usually for one, three, or six months in the future




If the forward rate of the euro (€/US$) is exactly the same as
the spot rate
 Euro is “flat”
If the forward rate of the euro is above the spot rate
 Euro is at a “forward discount”
If the forward rate of the euro is below the spot rate
 Euro is at a “forward premium”
Hedging exchange rate exposure requires that firms have
expectations or forecasts of future spot rates that they can
compare to forward rates
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