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Chapter05WhatDeterminesExchangeRates?Thinkingintermsofsupplyanddemandisanecessaryfirststeptowardunderstandingexchangerates.Thenextstepistheonethathastobetakeninanymarketanalysis:findingoutwhatunderlyingforcescausesupplyanddemandtochange.Sincethegeneralshifttofloatingexchangeratesintheearly1970s,exchangeratesbetweentheU.S.dollarandothermajorcurrencieshavebeenvariableorvolatile.Chapter05WhatDeterminesEx1Figure5.1remindsusjusthowvariableexchangerateshavebeen.(PanelA)Figure5.1remindsusjusthow2PanelBPanelB3Thechartssuggestthreetypesofvariability.First,therearelong-termtrendsinwhichsomecurrenciestendtoappreciateagainstthedollar,andotherstendtodepreciate.Second,therearemedium-termtrendswhicharesometimescountertothelongertrends.Third,thereisasubstantialvariabilityduringtheshortrun(frommonthtomonth,andindeed,fromdaytoday,hourtohour,andevenminutetominute).Thechartssuggestthreetypes4Whydoweseelargechangesinthevaluesoffloatingexchangerates?Howdoesshort-runvariabilityturnintolong-runtrends?Whyaremedium-runtrendssometimesoppositetotheselongertrends?Whydoweseelargechangesin55.1ExchangeRatesintheShortRun5.2TheLongRun:PurchasingPowerParity(PPP)5.3TheLongRun:TheMonetaryApproach5.4ExchangeRateOvershooting5.5HowWellCanWePredictExchangeRates5.1ExchangeRatesintheShor65.1

ExchangeRatesintheShortRunToanalyze,weusetheconceptofuncoveredinterestparityfromchapter4.RecallthatinvestorsdeterminetheexpectedoverallreturnonanuncoveredinvestmentinabonddenominatedinaforeigncurrencybyusingThebasicreturnonthebonditself(theinterestrateoryield),andTheexpectedgainorlossoncurrencyexchanges(theexpectedappreciationordepreciationoftheforeigncurrency).5.1

ExchangeRatesintheSho7Uncoveredinterestparitylinkstogetherfourvariables:thedomesticinterestrate,theforeigninterestrate,thecurrentspotexchangerateandtheexpectedfuturespotexchangerate.Changeinanyoneofthesefourvariablesimpliesthatadjustmentswilloccurinoneormoreoftheotherthree.Uncoveredinterestparitylink8TheRoleofInterestRatesSupposethedomesticinterestrate(i)increases,whiletheforeigninterestrate(if)andthespotexchangerateexpectedatsomeappropriatetimeinthefuture(eex)remainconstant,iftheinternationalinvestorswanttoshifttowarddomesticcurrencyassets,theyfirstneedtobuydomesticcurrencybeforetheycanbuythedomestic-currencybonds.Thisincreaseindemandfordomesticcurrencyincreasesthecurrentspotexchangeratevalueofdomesticcurrency,sotheforeigncurrencydepreciates(thehomecurrencyappreciates).Giventhespeedwithwhichfinancialinvestorscaninitiateshiftsintheirportfolios,theeffectonthespotexchangeratecanhappenveryquickly(instantaneouslyorwithinafewminutes).TheRoleofInterestRatesSupp9Forexample,page73.Iftheforeigninterestrateincreases,thentheforeigncurrencyappreciates.Thenwhathappensifbothinterestrateschangeatthesametime?Theansweristhatwhatreallymattersisthechangeintheinterestdifferentialif-i.Forexample,page73.10TheRoleoftheExpectedFutureSpotExchangeRateSupposethattheinterestratedifferentialisunchanged,thefinancialinvestorsnowexpectthefuturespotexchangeratetobehigherthantheypreviouslyexpected,iftheinvestorswanttoshifttowardforeign-currencyassets,theyfirstneedtobuyforeigncurrency.Thisincreaseindemandforforeigncurrencyincreasesthecurrentspotexchangeratee.(Theforeigncurrencyappreciates;thedomesticcurrencydepreciates.)Forexample,page74.TheRoleoftheExpectedFutur11Aswithachangeininterestrates,theeffectofachangeintheexpectedfuturespotrateonthecurrentspotexchangeratecanhappenveryquickly(instantaneouslyorwithinafewminutes).Giventhepowerfuleffectswhatexchange-rateexpectationscanhaveonactualexchangerates,we’dliketoknowwhatdeterminestheseexpectations.Manydifferentthingscaninfluencethevalueoftheexpectedfutureexchangerate.Aswithachangeininterestr12First,ifexpectationssimplyextrapolaterecenttrends,thenabandwagonispossible.Speculationthenmaybebasedondestabilizingexpectations—expectationsformedwithoutregardtotheeconomicfundamentals—and(speculative)bubblescanoccur.Second,ifexpectationsarebasedonabeliefthatexchangerateseventuallyfollowPPP,thentheyleadtostabilizingspeculation—speculationthattendtomovetheexchangeratetowardavalueconsistentwiththeeconomicfundamentalsofnationalpricelevels.Third,expectationsareaffectedbyvariouskindsofnewsabouteconomicandpoliticalcircumstances.Overall,Figure5.2providesaroadmapbysummarizingtheeffects.First,ifexpectationssimply13Figure5.2Figure5.2145.2TheLongRun:PurchasingPowerParity(PPP)Intheshortrun,floatingexchangeratesareoftenhighlyvariable,andtherearetimeswhenitisnoteasytounderstandwhytheratesarechangingastheyare.Inthelongrun,economicfundamentalsbecomedominant,providingan“anchor”forthelong-termtrends.Ourunderstandingofexchangeratesinthelongrunisbasedonthepurchasingpowerparity(PPP)hypothesis.ThreeversionsofPPParepresented:thelawofonepriceforasingleproduct,absolutePPP,andrelativePPP.5.2TheLongRun:PurchasingP15TheLawofOnePriceThelawofonepricepositsthataproductthatiseasilyandfreelytradedinaperfectlycompetitiveglobalmarketshouldhavethesamepriceeverywhere,oncethepricesatdifferentplacesareexpressedinthesamecurrency.Itproposesthattheprice(P)oftheproductmeasuredindomesticcurrencywillbeequatedtotheprice(Pf)oftheproductmeasuredintheforeigncurrencythroughthecurrentspotexchangerate(e,domesticcurrency/foreigncurrency):P=e·PfTheLawofOnePriceThelawof16BigMacindex

Forexample,usingfiguresinJuly2008:thepriceofaBigMacwas$3.57intheUnitedStates(Variesbystore)thepriceofaBigMacwas£2.29intheUnitedKingdom(Britain)(Variesbyregion)theimpliedpurchasingpowerparitywas$1.56to£1,thatis$3.57/£2.29=1.56thiscompareswithanactualexchangerateof$2.00to£1atthetime[(2.00-1.56)/1.56]*100=+28%thepoundwasthusovervaluedagainstthedollarby28%BigMacindex17Thelawofonepriceworkswellforheavilytradedcommodities,includinggold,othermetals,crudeoilandvariousagriculturalcommodities.However,itdoesnotholdcloselyformostproductsthataretradedinternationally,includingnearlyallmanufacturedproducts.Internationaltransportcostsareimperfectlycompetitive,governmentsdonotpracticefreetrade,manymarketsareimperfectlycompetitive,firmswithmarketpowersometimesusepricediscriminationtoincreaseprofitsbychargingdifferentpricesindifferentnationalmarkets.Formanyproducts,thelawofonepricedoesnotholdclosely.

Thelawofonepriceworkswel18AbsolutePurchasingPowerParityAbsolutePPPpositsthatabasketofproductswillhavethesamepriceinallcountrieswhenthepricesareconvertedintoasinglecurrencyusingthemarketexchangerates.P=e·PfWherePandPfrefertotheaverageproductpriceindomesticandforeigncountry,andeistheexchangeratemeasuredasunitsofdomesticcurrencyperunitofforeigncurrency.AbsolutePurchasingPowerPari19TheequationcanberearrangedtoprovideanestimateofthespotexchangeratethatisconsistentwithabsolutePPP:e=P/PfAbsolutePPPisclearlycloselyrelatedtothelawofoneprice.However,basedontheevidence,absolutePPPdoesnotfaremuchbetterthanthelawofonepriceintherealworld.Theequationcanberearranged20RelativePurchasingPowerParityBoththelawofonepriceandabsolutePPParepositedtoholdatapointintime.AnotherversionofPPPlooksathowthingsarechangingovertime.RelativePPPpositsthattheexchangeratewillchangetooffsetdifferencesbetweenchangesinproduct-pricelevelsindifferentcountries.Theformulais:(et/e0)=(Pt/P0)/(Pf,t/Pf,0)Wherethesubscript0indicatesvaluesintheinitialyearandthesubscripttindicatesvaluesinasubsequentyear.RelativePurchasingPowerPari21RelativePPPisoftendefinedusinganapproximation.Theratioofthetwoexchangeratescanbeapproximatedbythepercentagerateofappreciation(depreciationifnegative)oftheforeigncurrencyovertime.Theratioofthecountry’sproductpricelevelscanbeapproximatedbythepercentageincreaseinthepricelevelovertime,whichistheinflationrate.RelativePPPcanthenbestatedapproximatelyas:Rateofappreciationoftheforeigncurrency=π–πfWhereπandπfaretheinflationratesforthedomesticandforeigncountry.RelativePPPisoftendefined22RelativePPPprovidessomestrongpredictionsaboutexchangeratetrends,especiallyinthelongterm.Itimpliesthatlow-inflationcountriestendtohaveappreciatingcurrenciesandhighinflationcountriestendtohavedepreciatingcurrencies.Infact,astrictapplicationofPPPimpliesthateachpercentagepointmoreofacountry’sinflationperyeartendstoberelatedtoa1percentfasterrateofdepreciationofthecountry’scurrencyperyear.RelativePPPprovidessomestr23RelativePPP:RecentExperienceIt’ssuggestedthatPPPholdsreasonablywellinthelongrun,butpoorlyintheshortrun.Figure5.3providesevidenceonthelongrunduringthecurrentperiodoffloatingexchangerates.WecanalsoexamineperformanceofPPPforbothshortandlongperiodsusingdataontheexchangeratesofindividualcountriesovertime.Figure5.4showstheactualexchangeratesagainsttheU.S.dollarandtheexchangeratesthatwouldbeconsistentwithPPPforGermanMark(DM)andJapaneseyen.RelativePPP:RecentExperienc24TheexaminationshowsthatthereisatendencytofollowrelativePPPinthelongrun,buttherearealsosubstantialdeviationsfromrelativePPPintheshortrun.Theexaminationshowsthatthe255.3TheLongRun:TheMonetaryApproachPurchasingpowerparityindicatesthat,atleastinthelongrun,exchangeratesarecloselyrelatedtothepricelevelsindifferentcountries.Butthissuggeststhenextquestion:whatdeterminestheaveragenationalpricelevels?Economistsbelievethatinthelongrun,themoneysupply(oritsgrowthrate)determinesthepricelevel(orinflationrate),throughtheequilibriumbetweenmoneysupplyandmoneydemand.5.3TheLongRun:TheMonetary26Money,PriceLevels,andInflationThelinkbetweendomesticproductandthedemandforanation’smoneyiscentraltothequantitytheoryofdemandformoney.Thequantitytheoryequationsaysthatinanycountrythemoneysupplyisequatedwiththedemandformoney,whichisdirectlyproportionaltothemoneyvalueofgrossdomesticproduct.Money,PriceLevels,andInfla27Forhomecountryandtherestoftheworld,theequationmaybe:Ms=k·P·YMsf=kf·Pf·YfWhereMsandMsfarethehomeandforeignmoneysupplies;PandPfarethehomeandforeignpricelevels;YandYfaretherealdomesticproducts(thatisrealGDP).Theexplanationofkandkf

areasfollow.Forhomecountryandtherest28Foreachcountry,thenominalormoneyvalueofGDPequalsthepriceleveltimestherealGDP(PYandPfYf).kandkfindicatetheproportionalrelationshipsbetweenmoneyholdingsandthenominalvalueofGDP.Theyrepresentpeople’sbehavior.IfthevalueofGDPandthusthevalueoftransactionsincrease,kindicatestheamountofextramoneythatpeoplewanttoholdtofacilitatethishigherlevelofeconomicactivity.Sometimesquantitytheoriesassumethattheksareconstant,sometimesnot.Thefactsarethatanykvaries.Foreachcountry,thenominal29Forpresentanalysis,supposeeachmoneysupply(MsandMsf)iscontrolledbyeachcountry’smonetarypolicy,andthateachcountry’srealproduction(YandYf)isgovernedbysuchsupply-sideforcesasfactorsupplies,technology,andproductivity.Rearrangingtheterms,wecanusethequantitytheoryequationsofmoneysupplytodeterminetheratioofpricesbetweencountries:P/Pf=(Ms/Msf)·(kf/k)·(Yf/Y)Forpresentanalysis,suppose30MoneyandPPPCombinedCombiningPPPandthequantitytheoryequationsfortwocountries,weobtainapredictionofexchangeratesbasedonmoneysuppliesandnationalproducts:e=P/Pf=(Ms/Msf)·(kf/k)·(Yf/Y).Theequationpredictsthataforeignnationwillhaveanappreciatingcurrency(eup)ifithassomecombinationofslowermoneysupplygrowth(Ms/Msfup),fastergrowthinrealGDP(Yf/Yup),orariseintheratiokf/k.Conversely,anationwithfastmoneygrowthandastagnantrealeconomyislikelytohaveadepreciatingcurrency.MoneyandPPPCombinedCombinin31Goingonestepfurther,theequationimpliesthatsomekeyelasticitiesareequalto1.Thatis,iftheratio(kf/k)staysthesame,thenerisesby1percentforEach1percentriseinthedomesticmoneysupply(Ms),orEach1percentdropintheforeignmoneysupply(Msf),orEach1percentdropindomesticrealGDP(Y),orEach1percentriseinforeignGDP(Yf).Goingonestepfurther,theeq32Theexchangerateelasticitiesimplysomethingelsetoo:Anexchangeratewillbeunaffectedbybalancedgrowth.Ifmoneysuppliesgrowatthesamerateinallcountries,leavingMs/Msfunchanged,andifdomesticproductsgrowatthesamerate,leavingYf/Yunchanged,thereshouldbenochangeintheexchangerate.Theexchangerateelasticities335.4ExchangeRateOvershootingOurviewofexchangeratesasbeingdeterminedinthelongrunbypurchasingpowerparity,withitsemphasisonaverageratesofinflationovermanyyears,seemsquiteremovedfromtheviewthatexchangeratesintheshortrunarestruckbyrapidshiftsininvestor’sportfoliodecisions.Yetthetwomustberelated.Theshortruneventuallyflowsintothelongrun.5.4ExchangeRateOvershooting34Itisusefultoconsiderthisrelationshipinmoredepth,toexplorethephenomenonofovershooting.Internationalinvestorscanreactrationallytonewsbydrivingtheexchangeratepastwhattheyknowtobeitsultimatelong-runequilibriumvalue.Theactualexchangeratethenmovesslowlybacktothatlong-runratelateron.Itisusefultoconsiderthis35Thatis,intheshortrun,theexchangerateovershootsitslong-runvalueandthenrevertsbacktowardit.Thatis,intheshortrun,the36Supposethatthedomesticmoneysupplyunexpectedlyjumps10percentattimet0andthenresumestherateofgrowthinvestorshadalreadybeenexpecting.Investorsunderstandthatthispermanentincreaseof10percentshouldeventuallyraisethepriceofforeignexchangeby10percent,iftheybelievethatPPPandthemonetaryapproachholdeventually.Inthelongrun,boththedomesticpricelevel(P)andthepriceofforeignexchange(e)shouldbe10percenthigher.Supposethatthedomesticmone37Tworealisticsideeffectsoftheincreaseinthedomesticmoneysupplyinterveneandmaketheexchangeratetakeastrangepathtoitsultimate10percentincrease:(1)Productpricesarestickyintheshortrun,soconsiderabletimemustpassfordomesticinflationtoraisedomesticpricesPby10percent(relativetoforeignprices).(2)Becausepricesarestickyatfirst,theincreaseinthemoneysupplydrivesdownthedomesticinterestrate,bothrealandnominal.Tworealisticsideeffectsof38Withthedomesticinterestrate(i)lower,thereturndifferentialshiftstofavorforeign-currencyassets.Inaddition,theexpectedfuturespotexchangerateshouldincrease.Therefore,theoverallreturndifferentialactuallyfavorsforeign-currencyassetsfortworeasons:(1)Thedomesticinterestratehasdecreased,and(2)Theforeigncurrencyisexpectedtoappreciate.Withthedomesticinterestrat39Theinvestors’portfoliosrepositionincreasesthedemandforforeigncurrencyandresultsinaquickappreciationoftheforeigncurrency.Thenextquestionisbyhowmuchwilltheforeigncurrencyappreciateimmediately?Theansweristhecurrentspotexchangeratemustriseimmediatelybymorethan10percent.Afterthisrapidadjustment,themuchhigherspotratewillthenslowlydeclinebacktowarditsexpectedfuturevalue.Theinvestors’portfoliosrepo40Hereweshowshowexchangeratescanbehighlyvariableintheshortrun,whileatthesametimeeventuallychangeinthelongruninwaysconsistentwithPPP.Figure5.6showsit.Hereweshowshowexchangerat41Figure5.6Figure5.6425.5HowWellCanWePredictExchangeRatesOnepurposeofhavingtheoriesistopredicttheexchangeratesintherealworld.Internationalexperiencesincetheswitchtofloatingexchangeratesintheearly1970sprovidesarichdatasetforustotestthevalueofourtheories.Butitisstilldifficulttopredictexchangeratemovementsintheshortrun.Generally,wecannotbeatthenaivemodelofarandomwalk,whichpredictsthattheexchangerateinthefuturewillsimplybethesameastheexchangeratetoday.5.5HowWellCanWePredictEx43Thenwhyisitdifficulttopredictintheshortrunusingeconomicmodels?Thereappeartobetworeasons.First,andprobablymoreimportant,isthatthecurrentspotexchangeratereactsquicklyandstronglyto

unexpected(andthereforeunpredictable)news(ornewinformation).Inaddition,casualobservationindicatesthattheexchangeratereactstonewinformationconcerningbothactualeventandchangesinprobabilitiesaboutwhatwillhappen,notonlyforeconomicvariablesbutalsoforpoliticalvariablessuchaselections,appointments,internationaltensions,andwars.Thenwhyisitdifficulttopr44Thesecondreasonisthatexchangerateexpectationscanbeformedwithoutmuchreferencetoeconomicfundamentals.Surveysindicatethatmanyforeignexchangemarketparticipantsjustpredictthelatesttrendsuptoonemonthahead.Becausetheactionstakenbyinvestorscanmaketheirexpectationsself-confirming,recenttrendsinexchangeratescanbereinforcedandpersistforawhile.Iftheresultingmovementintheexchangerateappearstobesimplyinconsistentwithanyformofeconomicfundamentals,itiscalledabubble(orspeculativebubble).Thestrongpossibilitythatbubblesoccurintheforeignexchangemarketfromtimetotimesuggeststhatthereissomeeconomicinefficiencyinforeignexchangemarkets.Thesecondreasonisthatexch45Summary94Summary9446Chapter05WhatDeterminesExchangeRates?Thinkingintermsofsupplyanddemandisanecessaryfirststeptowardunderstandingexchangerates.Thenextstepistheonethathastobetakeninanymarketanalysis:findingoutwhatunderlyingforcescausesupplyanddemandtochange.Sincethegeneralshifttofloatingexchangeratesintheearly1970s,exchangeratesbetweentheU.S.dollarandothermajorcurrencieshavebeenvariableorvolatile.Chapter05WhatDeterminesEx47Figure5.1remindsusjusthowvariableexchangerateshavebeen.(PanelA)Figure5.1remindsusjusthow48PanelBPanelB49Thechartssuggestthreetypesofvariability.First,therearelong-termtrendsinwhichsomecurrenciestendtoappreciateagainstthedollar,andotherstendtodepreciate.Second,therearemedium-termtrendswhicharesometimescountertothelongertrends.Third,thereisasubstantialvariabilityduringtheshortrun(frommonthtomonth,andindeed,fromdaytoday,hourtohour,andevenminutetominute).Thechartssuggestthreetypes50Whydoweseelargechangesinthevaluesoffloatingexchangerates?Howdoesshort-runvariabilityturnintolong-runtrends?Whyaremedium-runtrendssometimesoppositetotheselongertrends?Whydoweseelargechangesin515.1ExchangeRatesintheShortRun5.2TheLongRun:PurchasingPowerParity(PPP)5.3TheLongRun:TheMonetaryApproach5.4ExchangeRateOvershooting5.5HowWellCanWePredictExchangeRates5.1ExchangeRatesintheShor525.1

ExchangeRatesintheShortRunToanalyze,weusetheconceptofuncoveredinterestparityfromchapter4.RecallthatinvestorsdeterminetheexpectedoverallreturnonanuncoveredinvestmentinabonddenominatedinaforeigncurrencybyusingThebasicreturnonthebonditself(theinterestrateoryield),andTheexpectedgainorlossoncurrencyexchanges(theexpectedappreciationordepreciationoftheforeigncurrency).5.1

ExchangeRatesintheSho53Uncoveredinterestparitylinkstogetherfourvariables:thedomesticinterestrate,theforeigninterestrate,thecurrentspotexchangerateandtheexpectedfuturespotexchangerate.Changeinanyoneofthesefourvariablesimpliesthatadjustmentswilloccurinoneormoreoftheotherthree.Uncoveredinterestparitylink54TheRoleofInterestRatesSupposethedomesticinterestrate(i)increases,whiletheforeigninterestrate(if)andthespotexchangerateexpectedatsomeappropriatetimeinthefuture(eex)remainconstant,iftheinternationalinvestorswanttoshifttowarddomesticcurrencyassets,theyfirstneedtobuydomesticcurrencybeforetheycanbuythedomestic-currencybonds.Thisincreaseindemandfordomesticcurrencyincreasesthecurrentspotexchangeratevalueofdomesticcurrency,sotheforeigncurrencydepreciates(thehomecurrencyappreciates).Giventhespeedwithwhichfinancialinvestorscaninitiateshiftsintheirportfolios,theeffectonthespotexchangeratecanhappenveryquickly(instantaneouslyorwithinafewminutes).TheRoleofInterestRatesSupp55Forexample,page73.Iftheforeigninterestrateincreases,thentheforeigncurrencyappreciates.Thenwhathappensifbothinterestrateschangeatthesametime?Theansweristhatwhatreallymattersisthechangeintheinterestdifferentialif-i.Forexample,page73.56TheRoleoftheExpectedFutureSpotExchangeRateSupposethattheinterestratedifferentialisunchanged,thefinancialinvestorsnowexpectthefuturespotexchangeratetobehigherthantheypreviouslyexpected,iftheinvestorswanttoshifttowardforeign-currencyassets,theyfirstneedtobuyforeigncurrency.Thisincreaseindemandforforeigncurrencyincreasesthecurrentspotexchangeratee.(Theforeigncurrencyappreciates;thedomesticcurrencydepreciates.)Forexample,page74.TheRoleoftheExpectedFutur57Aswithachangeininterestrates,theeffectofachangeintheexpectedfuturespotrateonthecurrentspotexchangeratecanhappenveryquickly(instantaneouslyorwithinafewminutes).Giventhepowerfuleffectswhatexchange-rateexpectationscanhaveonactualexchangerates,we’dliketoknowwhatdeterminestheseexpectations.Manydifferentthingscaninfluencethevalueoftheexpectedfutureexchangerate.Aswithachangeininterestr58First,ifexpectationssimplyextrapolaterecenttrends,thenabandwagonispossible.Speculationthenmaybebasedondestabilizingexpectations—expectationsformedwithoutregardtotheeconomicfundamentals—and(speculative)bubblescanoccur.Second,ifexpectationsarebasedonabeliefthatexchangerateseventuallyfollowPPP,thentheyleadtostabilizingspeculation—speculationthattendtomovetheexchangeratetowardavalueconsistentwiththeeconomicfundamentalsofnationalpricelevels.Third,expectationsareaffectedbyvariouskindsofnewsabouteconomicandpoliticalcircumstances.Overall,Figure5.2providesaroadmapbysummarizingtheeffects.First,ifexpectationssimply59Figure5.2Figure5.2605.2TheLongRun:PurchasingPowerParity(PPP)Intheshortrun,floatingexchangeratesareoftenhighlyvariable,andtherearetimeswhenitisnoteasytounderstandwhytheratesarechangingastheyare.Inthelongrun,economicfundamentalsbecomedominant,providingan“anchor”forthelong-termtrends.Ourunderstandingofexchangeratesinthelongrunisbasedonthepurchasingpowerparity(PPP)hypothesis.ThreeversionsofPPParepresented:thelawofonepriceforasingleproduct,absolutePPP,andrelativePPP.5.2TheLongRun:PurchasingP61TheLawofOnePriceThelawofonepricepositsthataproductthatiseasilyandfreelytradedinaperfectlycompetitiveglobalmarketshouldhavethesamepriceeverywhere,oncethepricesatdifferentplacesareexpressedinthesamecurrency.Itproposesthattheprice(P)oftheproductmeasuredindomesticcurrencywillbeequatedtotheprice(Pf)oftheproductmeasuredintheforeigncurrencythroughthecurrentspotexchangerate(e,domesticcurrency/foreigncurrency):P=e·PfTheLawofOnePriceThelawof62BigMacindex

Forexample,usingfiguresinJuly2008:thepriceofaBigMacwas$3.57intheUnitedStates(Variesbystore)thepriceofaBigMacwas£2.29intheUnitedKingdom(Britain)(Variesbyregion)theimpliedpurchasingpowerparitywas$1.56to£1,thatis$3.57/£2.29=1.56thiscompareswithanactualexchangerateof$2.00to£1atthetime[(2.00-1.56)/1.56]*100=+28%thepoundwasthusovervaluedagainstthedollarby28%BigMacindex63Thelawofonepriceworkswellforheavilytradedcommodities,includinggold,othermetals,crudeoilandvariousagriculturalcommodities.However,itdoesnotholdcloselyformostproductsthataretradedinternationally,includingnearlyallmanufacturedproducts.Internationaltransportcostsareimperfectlycompetitive,governmentsdonotpracticefreetrade,manymarketsareimperfectlycompetitive,firmswithmarketpowersometimesusepricediscriminationtoincreaseprofitsbychargingdifferentpricesindifferentnationalmarkets.Formanyproducts,thelawofonepricedoesnotholdclosely.

Thelawofonepriceworkswel64AbsolutePurchasingPowerParityAbsolutePPPpositsthatabasketofproductswillhavethesamepriceinallcountrieswhenthepricesareconvertedintoasinglecurrencyusingthemarketexchangerates.P=e·PfWherePandPfrefertotheaveragepro

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