Handout 4: Price Levels and Exchange Rates in the Long-Run

Question 1

The Law of One Price (LOOP)

Answer 1

In competitive markets free of transportation costs and official barriers to trade (such as tariffs), identical goods must sell for the same price in different countries, when prices are expressed in a common currency:

Pi = ePi* 
where Pi (Pi*) is the domestic (foreign) price of good i in domestic (foreign) currency and e is the nominal exchange rate (domestic currency per unit of foreign currency).

Question 2

Purchasing Power Parity (PPP)

Answer 2

The exchange rate between two countries’ currencies equals the ratio of the countries’ price levels

It predicts that an increase in the domestic price level will be associated with a proportional depreciation of domestic currency (an increase in e)

Question 3

Relative PPP

Answer 3

the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels (inflation rates)

Question 4

Real Exchange Rate

Answer 4

The real exchange rate between two countries’ currencies is the foreign price of a foreign representative basket, converted to domestic currency, relative to that of the domestic economy:

RER: eP*/P

Question 5

What does theBalassa - Samuelson Model argue?

Answer 5

They argue that there is a strong correlation between per capita income and price levels between countries. Richer countries tend to have higher price levels.

This is especially true for the price of non-tradeables.

The model shows why this is possible and also explains why PPP can fail even if the Loop holds for tradeable goods.

Question 6

Engels and Rogers

Answer 6

Failure of One Loop Price (LOOP) has been widely documented: similar goods sold in different locations have different prices, suggesting less than perfect market integration.

Reasons: Geographical separation of markets is an obvious reason (distance proxies for transportation costs, or less similar cost structures). Arbitrage is more difficult.

Question 7

What are the assumptions in the Balassa Samuelson model?

Answer 7

• 2 countries: Home is the poor country and Foreign is the rich country.
• Two goods tradeable (T) and non-tradeable goods (N).
• Labour is the only factor of production and is perfectly mobile within countries but completely immobile between countries.
  Technology: the countries are equally productive in nontradeable (N) but Foreign is more productive in the tradeable sector (T).

Yn=AnLn Yn=AnLn => An=An
Yt=AtLt Y=AtLt At < At
A= Productivity, L= Labour N= Non tradeables T= Tradeables

Question 8

In the Balassa Samuelson model, what is the profit maximisation condition by firms in all sectors?

Answer 8

Profit maximisation by firms in all sectors implies:
Wn = AnPn and Wt=AtPt
Wn=AnPn and Wt=AtPt
Where W’s are the wage rates in each of the different sectors.

Question 9

In the Balassa Samuelson Model what does Labour mobility within countries imply?

Answer 9

LABOUR MOBILITY WITHIN COUNTRIES IMPLIES WAGES EQUALISATION BETWEEN SECTORS IN EACH COUNTRY.

Wn=Wt and W*n = W*t
=>
AnPn=AtPt
A*nP*n = A*tP*t
We get:
Pn/Pt = At= An and P*n/P*t=A*t/A*n

Question 10

What are the findings and conclusions of the Balassa Samuelson model?

Answer 10

In terms of technology (productivity), we assumed that An= A*n and At <a>At) implies higher wages in the whole economy (Wn = Wt) which further implies higher prices in the non tradeable sector. The total price level in the rich countru (composed of both tradeables and non-tradeables is therefore higher than in the poor country
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