Transcript Classical Economics & Relative Prices

Classical Economics & Relative
Prices
Classical Economics

Classical economics relies on three main
assumptions:
Classical Economics

Classical economics relies on three main
assumptions:
Markets are perfectly competitive
 All prices are flexible
 Markets clear (equilibrium)

Classical Economics

Classical economics relies on three main
assumptions:
Markets are perfectly competitive
 All prices are flexible
 Markets clear (equilibrium)


One key result is that all real variables
are independent of monetary policy
(money neutrality)
Savings, Investment, and the
Trade Balance

Recall that in a closed economy, demand for loanable
funds (supply of marketable securities) must equal
the supply of loanable funds (demand for marketable
securities)
Savings, Investment, and the
Trade Balance

Recall that in a closed economy, demand for loanable
funds (supply of marketable securities) must equal
the supply of loanable funds (demand for marketable
securities)
S = I + (G-T)
S = Private Savings
I = Private Investment
(G-T) = Government Deficit/Surplus
Savings/Investment in a Closed
Economy
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
Without access to world
capital markets, a country’s
private saving is the sole
source of funds. Therefore,
the domestic interest rate
must adjust to insure that
S = I + (G-T)
In this example, the
domestic interest rate is
equal to 10% and S = I
+(G-T) = 300
What will happen if we
expose this country to trade?
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Savings in the Open Economy

In an open economy, the rest of the
world becomes an added source of
demand/supply of marketable securities
S = I + (G-T) + NX
Further, perfect capital mobility insures
that all countries have the same (risk
adjusted) real interest rate.
Savings in the Open Economy
Again, a trade deficit implies NX<0
 Therefore, S – (I – (G-T)) = NX < 0

Savings in the Open Economy
Again, a trade deficit implies NX<0
 Therefore, S – (I – (G-T)) = NX < 0
 A country with a trade deficit is
borrowing from the rest of the world
 That is, domestic supply of marketable
securities is greater than domestic
demand

Adding Net Exports to Capital
Markets

Suppose that the prevailing
world (real) interest rate is
6%
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Adding Net Exports to Capital
Markets
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Suppose that the prevailing
world (real) interest rate is
6%
At 6%,
 S = $100
 I + (G-T) = $500
 NX = $100 - $500 = $400
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Adding Net Exports to Capital
Markets
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Suppose that the prevailing
world (real) interest rate is
14%
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Adding Net Exports to Capital
Markets

Suppose that the prevailing
world (real) interest rate is
14%
 S = $500
 I + (G-T) = $100
 NX = $500 - $100 =
$400
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Where does the world interest
rate come from?
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Aggregate world savings is
the sum of private savings
across countries
Aggregate Private
Investment and Government
Deficits are also summed
over all countries
By definition, NX summed
over all countries must equal
zero. Therefore, at the real
world equilibrium interest
rate,
S = I + (G-T)
In this example, r = 11%
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Example: An increase in
productivity
Suppose that trade is initially
balanced. A rise in
productivity increases
investment demand
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Example: An increase in
productivity
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Suppose that trade is initially
balanced. A rise in
productivity increases
investment demand
In a closed economy,
interest rates would rise
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Example: An increase in
productivity
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Suppose that trade is initially
balanced. A rise in
productivity increases
investment demand
In a closed economy,
interest rates would rise
In an open economy, the
trade deficit would increase.
In the case, the deficit
increases from zero to $15,000
Do interest rates rise at all?
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World Capital Markets
A country’s ability to influence world interest rates
depends on its size relative to the world economy
(recall, global interest rates are determined such that
global capital markets clear)
 The US makes up roughly 35% of the global
economy. Therefore, the US can significantly
influence global interest rates (as can Japan, EU, and
China)
 The rest of the world has little influence unless it acts
as a unified group (Latin American Financial Crisis,
Asian Crisis)

Exchange Rates and Price
Levels


The Law of One Price
(LOOP) states that the same
product should cost the
same in every location
For example, suppose that
the price of a television is
$200 in the US and E190 in
Europe. The current
exchange rate is $1.17/E
Exchange Rates and Price
Levels

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The Law of One Price
(LOOP) states that the same
product should cost the
same in every location
For example, suppose that
the price of a television is
$200 in the US and E190 in
Europe. The current
exchange rate is $1.17/E
P* = E190 (E Price in Europe)
Exchange Rates and Price
Levels
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The Law of One Price
(LOOP) states that the same
product should cost the
same in every location
For example, suppose that
the price of a television is
$200 in the US and E190 in
Europe. The current
exchange rate is $1.17/E
What should happen here?
P* = E190 (E Price in Europe)
eP* = ($1.17/E)(E190)
= $222.30
Exchange Rates and Price
Levels
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The Law of One Price
(LOOP) states that the same
product should cost the
same in every location
For example, suppose that
the price of a television is
$200 in the US and E190 in
Europe. The current
exchange rate is $1.17/E
What should happen here?
A profit can be made by
buying TVs in the US and
selling them in Europe.
P* = E190 (E Price in Europe)
eP* = ($1.17/E)(E190)
= $222.30
Exchange Rates and Price
Levels

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The Law of One Price
(LOOP) states that the same
product should cost the
same in every location
LOOP states that in
equilibrium, no such profits
can occur. Therefore, P =
eP*
Exchange Rates and Price
Levels
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The Law of One Price
(LOOP) states that the same
product should cost the
same in every location
LOOP states that in
equilibrium, no such profits
can occur. Therefore, P =
eP*
If the price of a TV is $200
in the US and E190 in
Europe, the implied
exchange rate is $1.05/E
Exchange Rates and Price
Levels


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The Law of One Price
(LOOP) states that the same
product should cost the
same in every location
LOOP states that in
equilibrium, no such profits
can occur. Therefore, P =
eP*
If the price of a TV is $200
in the US and E190 in
Europe, the implied
exchange rate is $1.05/E
P = $200
P* = E190
P = eP*
Exchange Rates and Price
Levels



The Law of One Price
(LOOP) states that the same
product should cost the
same in every location
LOOP states that in
equilibrium, no such profits
can occur. Therefore, P =
eP*
If the price of a TV is $200
in the US and E190 in
Europe, the implied
exchange rate is $1.05/E
P = $200
P* = E190
P = eP*
e = P/P* = $200/E190
= $1.05/E
Purchasing Power Parity

Purchasing power parity (PPP) is simply LOOP applied to general
price indices
P = eP*
Purchasing Power Parity

Purchasing power parity (PPP) is simply LOOP applied to general
price indices
P = eP*

A more useful form of PPP is
%Change in e = Inflation – Inflation*
Purchasing Power Parity

Purchasing power parity (PPP) is simply LOOP applied to general
price indices
P = eP*

A more useful form of PPP is
%Change in e = Inflation – Inflation*

For example, if the US inflation rate (annual) is 4% while the
annual European inflation rate is 2%, the the dollar should
depreciate by 2% over the year.
PPP and the “Fundamentals”

Again, recall that PPP gives the following formula for
the nominal exchange rate:
e = P/P*
PPP and the “Fundamentals”


Again, recall that PPP gives the following formula for
the nominal exchange rate:
e = P/P*
Further, the quantity theory give the price level as a
function of money and output
P = MV/Y
PPP and the “Fundamentals”
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
Again, recall that PPP gives the following formula for
the nominal exchange rate:
e = P/P*
Further, the quantity theory give the price level as a
function of money and output
P = MV/Y
Combining the two,
e = (V/V*)(M/M*)(Y*/Y)
V,M,and Y are exchange rate “fundamentals”
PPP and the Real Exchange
Rate

While the nominal exchange rate is defined as
the dollar price of foreign currency, the real
exchange rate is defined as the price of
foreign goods in terms of domestic goods
q = eP*/P
PPP and the Real Exchange
Rate

While the nominal exchange rate is defined as
the dollar price of foreign currency, the real
exchange rate is defined as the price of
foreign goods in terms of domestic goods
q = eP*/P

PPP implies that the real exchange is
always constant (actually, its equal to 1)
Interest Rate Parity


Interest rate parity is the
asset equivalent of PPP. It
states that all assets should
be expected to earn the
same return
For example, suppose that
the interest rate in the US is
5%, the interest rate in
Europe is 7%,, the current
exchange rate is $1.15/E and
the anticipated exchange
rate in a year is $1.10/E
Interest Rate Parity


Interest rate parity is the
asset equivalent of PPP. It
states that all assets should
be expected to earn the
same return
For example, suppose that
the interest rate in the US is
5%, the interest rate in
Europe is 7%,, the current
exchange rate is $1.15/E and
the anticipated exchange
rate in a year is $1.10/E

Each $1 invested in the US
will be worth $1.05 in a year.
How about each $ invested
in Europe?
Interest Rate Parity


Interest rate parity is the
asset equivalent of PPP. It
states that all assets should
be expected to earn the
same return
For example, suppose that
the interest rate in the US is
5%, the interest rate in
Europe is 7%,, the current
exchange rate is $1.15/E and
the anticipated exchange
rate in a year is $1.10/E


Each $1 invested in the US
will be worth $1.05 in a year.
How about each $1 invested
in Europe?
$1 = (1/1.15) = .87E
.87E(1.07) = .93E
.93E ($1.10/E) = $1.02
Interest Rate Parity


Interest rate parity is the
asset equivalent of PPP. It
states that all assets should
be expected to earn the
same return
For example, suppose that
the interest rate in the US is
5%, the interest rate in
Europe is 7%,, the current
exchange rate is $1.15/E and
the anticipated exchange
rate in a year is $1.10/E
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Each $1 invested in the US
will be worth $1.05 in a year.
How about each $1 invested
in Europe?
$1 = (1/1.15) = .87E
.87E(1.07) = .93E
.93E ($1.10/E) = $1.02
Even with the higher return
in Europe, the 5%
appreciation of the dollar
makes the US asset a better
investment. Therefore,
funds will flow to the US.
Interest Rate Parity

Interest parity states that exchange
rates should be expected to adjust such
that assets pay equal returns across
countries
(1+i) = (1+i*)(e’/e)
Interest Rate Parity

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
Interest parity states that exchange rates should be
expected to adjust such that assets pay equal returns
across countries
(1+i) = (1+i*)(e’/e)
A more useful form is
i – i* = % change in e
For example, if the interest rate in the US is 5% and
the interest rate in Japan is 2%, the dollar should
depreciate by 3% against the Yen
Interest Rate Parity




Interest parity states that exchange rates should be
expected to adjust such that assets pay equal returns
across countries
(1+i) = (1+i*)(e’/e)
A more useful form is
i – i* = % change in e
For example, if the interest rate in the US is 5% and
the interest rate in Japan is 2%, the dollar should
depreciate by 3% against the Yen
Interest rate parity fails just as badly as PPP.
Interest Rate Parity & PPP

Recall that PPP gives the following:
% change in e = Inflation – Inflation*
Interest Rate Parity & PPP


Recall that PPP gives the following:
% change in e = Inflation – Inflation*
Interest Parity gives the following:
i – i* = % change in e
Interest Rate Parity & PPP



Recall that PPP gives the following:
% change in e = Inflation – Inflation*
Interest Parity gives the following:
i – i* = % change in e
Combining them gives us
i – i* = Inflation – Inflation*
Interest Rate Parity & PPP



Recall that PPP gives the following:
% change in e = Inflation – Inflation*
Interest Parity gives the following:
i – i* = % change in e
Combining them gives us
i – i* = Inflation – Inflation*
i – Inflation = i* - Inflation*
Interest Rate Parity & PPP



Recall that PPP gives the following:
% change in e = Inflation – Inflation*
Interest Parity gives the following:
i – i* = % change in e
Combining them gives us
i – i* = Inflation – Inflation*
i – Inflation = i* - Inflation*
r = r*
Summary of Classical Exchange Rate
Theory
Real interest differentials across countries are
zero.
 The trade balance is equal to S – (I + (G-T))
at the world interest rate
 Real exchange rates are constant
 Nominal Exchange rates are related to the
“fundamentals”

e = (V/V*)(M/M*)(Y*/Y)

There is no obvious correlation between trade
balances, interest rates and exchange rates
Exchange Rates & the
Fundamentals (JPY/USD)
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PPP
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Exchange Rates & the
Fundamentals (GBP/USD)
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PPP
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Nominal/Real Exchange Rates
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Yen/$
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Nominal/Real Exchange Rates
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Yen/$
Real
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Nominal/Real Exchange Rates
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GBP/$
Real
Explaining Deviations from
PPP
Transportation costs, tariffs, taxes, etc.
interfere with LOOP
 Non-Traded goods
 Changes in Terms of Trade
 Price indices are constructed differently
 Fixed prices in the short run (Keynesian
Economics)

Trading Costs: An Example

Suppose that the price of gold in Britain is
L 210 while the price of gold in the US is
$300
Trading Costs: An Example
Suppose that the price of gold in Britain is
L 210 while the price of gold in the US is
$300
 The LOOP exchange rate (GBP/USD)will be
equal to

e = P*/P = L 210 / $300 = L.7/$
Trading Costs: An Example
Suppose that the price of gold in Britain is
L 210 while the price of gold in the US is
$300
 The LOOP exchange rate (USD/GBP) will be
equal to

e = P/P* = $300 / L210 = $1.43/L

If the exchange rate deviates from .1.43,
profits from arbitrage would be
P – eP* (Buy in GB, sell in US)
eP* - P (Buy in US, sell in GB)
Trading Costs: An Example
Now, assume a $10 trading cost
 Profits from arbitrage would now be

P – (eP*+10) (Buy in GB, sell in US)
eP* - (P+10) (Buy in US, sell in GB)
Trading Costs: An Example


Now, assume a $10 trading cost
Profits from arbitrage would now be
P – (eP*+10) (Buy in GB, sell in US)
eP* - (P+10) (Buy in US, sell in GB)

Solving for the exchange rate gives us a range in
which arbitrage is not profitable
(P-10)/P* < e < (P+10)/P*
1.38
< e < 1.47
Trading Costs: An Example
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Actual
Non-Traded Goods: An
Example

Suppose that in addition to gold, we add theatre
tickets. Theatre tickets in the US cost $40 while in
Britain, similar tickets cost L 30. Further, assume
that the price index is defined (in both Britain and the
US) as P = .3(Tickets) + .7(Gold)
Non-Traded Goods: An
Example

Suppose that in addition to gold, we add theatre
tickets. Theatre tickets in the US cost $40 while in
Britain, similar tickets cost L 30. Further, assume
that the price index is defined (in both Britain and the
US) as P = .3(Tickets) + .7(Gold)

CPI = .3(40) + .7(300) = $222
CPI* = .3(30) + .7(210) = L156

Non-Traded Goods: An
Example



CPI* = .3(30) + .7(210) = L156
CPI = .3(40) + .7(300) = $222
Arbitrage will insure the nominal exchange rate will
equal

E = P/P* = 300/210 = $1.43/L
Non-Traded Goods: An
Example



CPI* = .3(30) + .7(210) = L156
CPI = .3(40) + .7(300) = $222
Arbitrage will insure the nominal exchange rate will
equal


e = P/P* = 300/210 = $1.43/L
The real exchange rate equals

q = e(CPI*/CPI) = 1.43(156/222) = 1
Non-Traded Goods: An
Example

Suppose that the price of a theatre ticket in the US
increases to $50.
Non-Traded Goods: An
Example



Suppose that the price of a theatre ticket in the US
increases to $50.
CPI* = .3(30) + .7(210) = L156
CPI = .3(50) + .7(300) = $225
Non-Traded Goods: An
Example

Suppose that the price of a theatre ticket in the US
increases to $50.
CPI* = .3(30) + .7(210) = L156
CPI = .3(50) + .7(300) = $225

the nominal exchange rate stays at



e = P/P* = 300/210 = $1.43/L
Non-Traded Goods: An
Example

Suppose that the price of a theatre ticket in the US
increases to $50.
CPI* = .3(30) + .7(210) = L156
CPI = .3(50) + .7(300) = $225

the nominal exchange rate stays at




e = P/P* = 300/210 = $1.43/L
The real exchange rate equals

q = e(CPI*/CPI) = 1.43(156/225) = .991 (A real
appreciation)
Relative Prices and Classical
Economics

Classical theory begins with the real
exchange rate (q)
Relative Prices and Classical
Economics
Classical theory begins with the real
exchange rate (q)
 Given movements of the real exchange rate,
the nominal exchange rate evolves according
to
 e = q(Fundamentals)
= q(V/V*)(M/M*)(Y*/Y)

Example

The US dollar experienced a sharp
appreciation during the eighties.
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Example
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GBP/$
Real
Example
The US dollar experienced a sharp
appreciation during the eighties.
 This could be explained by an increase in the
relative price of non-tradeables





Globalization lowered manufactured goods prices
Falling equipment prices (computers)
Rising cost of services (healthcare)
This, however, can’t explain the decline in the
dollar in the late eighties
Real exchange rates and real
interest differentials

Recall the interest parity condition


(i-i*) = %change in e
Subtracting inflation from both sides
gives us a real interest parity condition

(r-r*) = %change in q
Relative Prices and the Trade
Balance


(r-r*) = %change in q
Therefore, a real
depreciation (an
increase in q) forces a
rise in domestic interest
rates (to compensate
for declining dollar
values)
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Relative Prices and the Trade
Balance

Higher interest rates
increase domestic
savings while lowering
domestic investment.
This improves the trade
balance
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Classical Exchange Rate Theory and
Relative Prices
Real exchange rates are determined by
relative price changes
 Nominal Exchange rates are related to the
real exchange rate plus the “fundamentals”

e = q (V/V*)(M/M*)(Y*/Y)
Real interest differentials across countries are
positively related to real exchange rate
changes
 Real depreciations (appreciations) will
improve (worsen) the trade balances.
