International Macro Part 6 Purchasing Power Parity Basics

– So in this video segment we’re
going to talk about theories of the determinants, or what determines,
of the real exchange rate and we’re also actually
going to talk about real and nominal exchange rate. And before we go too far
into our long run theory, let me go ahead and make sure that I point out we’re not
trying to explain the short run in this case. In the short run,
movements and exchange rates are almost all purely financial
and in particular, depend very, very heavily
on short run interest rates and changes in relative
short run interest’s rates. So that if short run interest
rates rise in the US relative to some other country
than a bunch of investors are going to want to move some of
their money into the US dollar and that’s going
to push the US dollar up and so on and so forth. So a rise
in a countries relative interest rates is often going to cause
an appreciation of its currency. And a little
bit depends on exactly why there was a rise
in the relative interest rates. If it was a rise
in the relative interest rates because people thought
the country had become riskier and were wanting
to withdraw their money, then it would sort
of have the opposite effect. But in general if say,
for instance, a central
bank raises interest rates in a country then it’s
going to lead typically to an appreciation
of the currency, if it decreases
interest rates that’s typically going to lead to a depreciation
of the currency. But this kind of thing isn’t
our main topic for this chapter and in the long run we think exchange rates are
best explained by this sort of arbitrage phenomenon that we
saw in the last video segment and what we call
Purchasing Power Parody theory. So Purchasing Power Parody is
often written as PPP, Purchasing Power Parody. And remember that was that idea that arbitrage causes the real
exchange rate to go to one. And you can see why this is
called Purchasing Power Parody, because when the real
exchange rate equals one than buying a hotel room or a ream of paper is equally
expensive in all countries. Another way of saying
this is remember that the real
exchange rate is equal to the nominal
exchange rate times the ratio of the two
price levels. So we’re predicting then that
the nominal exchange rate times the ratio of these two price
levels equals one or if we, sort of, move this around, and we’re going
to multiply both sides by the price level
in the foreign country over the price level in the US
we’re going to get a prediction so this term’s going
to cancel out because this one cancels that one
and that one cancels that one. We’re going to get a prediction that the nominal
exchange rate is equal to the foreign price level
over the US price level, so that if the nominal exchange
rate is 100 yen per dollar we think that typically things
are going to be about 100 times as expensive in yen
as they are in dollars. Or if it’s 10 pesos
per the dollar, then a hamburger
that costs $3.00 in the US will probably
cost about 30 pesos in Mexico. So this is, in many ways,
a prediction of where the nominal
exchange rate’s going to head in the long run
so that in the long run we think changes in the nominal
exchange rate are due to changes in the relative price levels.

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