International Macroeconomics: Slides For Chapter 9: Determinants of The Real Exchange Rate
International Macroeconomics: Slides For Chapter 9: Determinants of The Real Exchange Rate
International Macroeconomics: Slides For Chapter 9: Determinants of The Real Exchange Rate
International Macroeconomics
Columbia University
May 1, 2016
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
says that a good should cost the same abroad and at home.
Pi = Pi∗S,
where
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
– labor
– rent
– electricity
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
Let:
P = domestic currency price of a domestic basket of goods
P ∗ = foreign currency price of a foreign basket of goods
S = nominal exchange rate, [domestic currency per unit of foreign
currency]
e = real exchange rate (RER)
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
If
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Suppose the LOOP holds for all goods, does PPP (i.e., e = 1) have
to hold?
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
Absolute PPP
We say that absolute PPP holds, when
e=1
Relative PPP
We say that relative PPP holds, when
∆e = 0
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
The next graph tests relative PPP by plotting ln(St Pt∗) and ln(Pt ) for
the dollar pound real exchange rate over the period 1820 to 2001.
The vertical difference between the broken and the solid line is et,
the dollar-pound real exchange rate.
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
Note: The figure shows U.S. and U.K. consumer price indices expressed in U.S. dollar terms over the period 1820-2001 using a log scale with a base of 1900=0. Source:
Alan M. Taylor and Mark P. Taylor, “The Purchasing Power Parity Debate,” Journal of Economic Perspectives 18, Fall 2004, 135-158.
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
1. Overall the comovement between U.S. and U.K. prices over the
past 180 years has been very high! This suggests that relative
PPP holds in the long run.
2. Over the past 180 years the dollar has appreciated significantly
vis-a-vis the Pound in real terms.
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
ln et − ln et−k = 0
This equation says that the difference between foreign long run
inflation and U.S. long run inflation should be equal to the rate
of depreciation of the foreign currency against the dollar.
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
Taylor and Taylor test whether relative PPP holds in the long run by
considering average inflation differentials and average depreciation
rates against the U.S. dollar over the 29 year period 1970 to 1998
for 20 industrialized countries and 26 developing countries. Each
country is one observation. If relative PPP holds in the long run,
then a plot of long-run inflation differentials against long-run depreciation
rates against the dollar should lie on the 45 degree line.
The next graph shows that this is indeed the case — providing more
support to the claim that in the long-run relative PPP holds.
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
Note: The figure shows countries’ cumulative inflation rate differentials against the United States in percent (vertical axis) plotted against their cumulative depreciation
rates against the U.S. dollar in percent (horizontal axis). The sample includes data from 20 industrialized countries and 26 developing countries. Source: Alan M. Taylor
and Mark P. Taylor, “The Purchasing Power Parity Debate,” Journal of Economic Perspectives 18, Fall 2004, 135-158.
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
A: No. As we saw above in the time series plot, the real exchange
rate, which in that plot is given by the difference between the two
lines, changes from year to year, and hence relative PPP fails in the
short run.
Summary:
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
Absolute PPP
It is very hard to get data for the level of Pt, because statistical
agencies that produce the CPI typically publish an index and not the
actual price level of a typical basket.
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
BigMac S × P BigMac∗
e =
P BigMac
eBigMac = 1 tells you how many U.S. Big Macs it takes to buy one
foreign Big Mac.
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ppp
Let St denote the PPP exchange rate, that is, the nominal exchange
rate that would make PPP hold, . That is,
ppp
St Pti = PtU S
This is the nominal exchange rate that would make the real exchange
rate equal to one.
If
StP P P > St ,
then
PtU S > St Pti
then we say that the dollar is overvalued (and the foreign currency
undervalued)
and iff StP P P < St , then
PtU S < St Pti
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and we say the dollar is undervalued (and the foreign currency
overvalued).
If one believes that in the long run PPP should hold for Big Macs,
then one would regard the currencies of Switzerland, Norway, Brazil,
and Sweden as overvalued and would expect them to depreciate
against the U.S. dollar over time. Similarly, one would expect all
the countries with a Big Mac real exchange rate less than one to
appreciate against the U.S. dollar over time.
We have just seen that absolute PPP fails for Big Macs. But is
there other data on price levels that can be used to test whether
absolute PPP holds. Yes. There is one source on actual price levels:
The International Comparison Program (ICP)
The 2011 ICP round collected over 7 million prices from 199 economies
in eight regions, with the help of 15 regional and international
partners. It is the most extensive effort to measure PPPs ever
undertaken.
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
The ICP reports the real exchange rate, which is referred to as the
‘Price Level Index’
SP ∗
e = PLI ≡
P
where now P ∗ and P are actual price levels (and not indices!).
Here is what they find for the year 2011 (most recent available):
Foreign Country e × 100
United States 100
Ethiopia 29 What do these numbers mean?
Bangladesh 31 Take India, a PLI of 32 means that
India 32
you can buy a basket that costs
Pakistan 28
China 54 $100 in the United States for $32
Germany 108 in India.
Sweden 136 ⇒ Absolute PPP fails!
Switzerland 162
Japan 135
Data Source: Purchasing Power Parities and Real Expenditures of World Economies, Summary of Results and Findings of the 2011 International Comparison Program,
Table 6.1, The World Bank, 2014.
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32%
50% 48%
67%
High−income
Middle−Income
Low−Income
The income categories are as follows: low income—per capita gross national income (GNI) less than $1,025 (32 countries); middle income—per capita GNI from $1,026
to $12,475 (84 countries); and high income—per capita GNI greater than $12,475 (56 countries).
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Not yet, in 2011, ICP reports that it is the second largest both at
PPP exchange rates and at market exchange rates. U.S. GDP at
market prices still twice as large as China’s. And to assess economic
power, it probably makes more sense to look at GDP at market
exchange rates.
GDP (PPP-based) GDP ($-based) Economy
Rank World Share World Share
1 17.1 22.1 United States
2 14.9 10.4 China
3 6.4 2.7 India
4 4.8 8.4 Japan
5 3.7 5.2 Germany
Data Source: Table 7.1 of “Purchasing Power Parities and Real Expenditures of World Economies, Summary of Results and Findings of the 2011 International
Comparison Program.”
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
Norway
200
180
Japan
160 Luxembourg
PLI, (World=100), 2011
140 Germany
United States
120
100
Qatar
80 Kuwait
Comoros
Congo, Dem. Rep. Macao SAR, China
Brunei Darussalam
China
Liberia
60 Niger
Burundi India
40
20
500 2000 8000 32000 128000
Natural Log Scale, GDP per capita at PPP exchange rates, 2011
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
⇒ $1,533 can buy 3 times as many goods in India (at Indian prices)
than it can in the U.S. at U.S. prices.
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
One reason is that many goods are not traded internationally, and
hence price discrepancies will not be arbitraged away via trade.
P = φ(PT , PN )
Example:
P = (PT )α(PN )1−α
PT = SPT∗
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but not for nontraded goods
∗
PN 6= SPN
P ∗ = φ(PT∗ , PN
∗)
∗
PN
if P ∗ > P
P
N , then e > 1.
T T
International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
Recall that:
∗
PN
φ 1, P ∗
e = PT
φ 1, PN
T
∗
PN
From here clear that the real exchange rate depreciates if P ∗ increases
T
relative to PN
PT
∗
PN
Q: What could make P ∗ go up relative to P
P
N?
T T
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
The Model
2 goods: QT and QN
QT = traded output
QN = nontraded output
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
Production
Production of Tradables:
QT = aT LT
Production of Nontradables:
QN = aN LN
LT = labor input in the traded sector
LN = labor input in the nontraded sector
aT = exogenous labor productivity in the traded sector
aN = exogenous labor productivity in the nontraded sector
W = wage rate
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
profits = PT QT − W LT .
subject to
QT = aT LT .
Eliminate QT
profits = PT aT LT − W LT
Choose LT to maximize profits
∂profits
= 0 ⇒ PT aT = W (*)
∂LT
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
profits = PN QN − W LN .
subject to
QN = aN LN .
Eliminate QN
profits = PN aN LN − W LN
Choose LN to maximize profits
∂profits
= 0 ⇒ PN aN = W (**)
∂LN
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
PN a
= T (2)
PT aN
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
!
PN
%∆ = %∆aT − %∆aN
PT
This expression says that the percent change in the relative price of
nontradables is equal to the growth rate differential between factor
productivity in the traded sector and the nontraded sector.
We wish to test whether this relationship holds over the long run in
actual data.
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Comments on the figure:
A relationship like equation (2) must also hold in the foreign country
PN∗ a∗T
= ∗
PT∗ aN
where
PT∗ = foreign currency price of traded goods abroad
PN∗ = foreign currency priced of nontraded goods abroad
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
a∗T
Hence e ↑, if a∗ increases relative to aaT , that is, the real exchange
N N
rate of the domestic country depreciates if relative productivity growth
in the traded sector relative to productivity growth in the nontraded
sector is faster in the foreign country than in the domestic country.
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
φ(PT , PN ) = PT1−αPN
α, α ∈ (0, 1)
a∗T
" ! !#
aT
%∆e = α %∆ − %∆
a∗N aN
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
Can the Balassa Samuelson model explain the observed real depreciation
of the German mark against the Japanese Yen and against the Italian
Lira in the 1970s and 1980s?
Consider the bilateral real exchange rate between the German Mark
(DM) and the Italian Lira (£): According to the Balassa Samuelson
model we have
aIT aG
" ! !#
%∆eDM/£ = α %∆ − %∆ T
aIN aG
N
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International Macroeconomics, Chapter 9 Schmitt-Grohé, Uribe, Woodford
Over the long run, here 1970 to 1993, Balassa Samuelson explains
well the observed real depreciation of the German mark against the
Italian Lira. For it shows that the relative growth rate of labor
productivity in the traded sector, relative to the nontraded sector,
was higher in Italy than in Germany.
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