TERM 1: RER Flashcards
LOOP STATES
the same good should cost the same abroad and at home.
LOOP formula for a given good i
Pi = Pi*S
The nominal ER measures
S = how much domestic currency is needed to buy 1 unit of foreign currency.
LOOP holds for (4)
Gold, oil, wheat, luxury consumer goods
LOOP fails for (5)
Big Mac; housing; transportation; haircuts; restaurant meals.
4 reasons why LOOP fails
- Good has non-traded inputs
- Gov policies / regulations e.g. taxes
- Barriers to trade e.g. tariffs/quotas
- Pricing to specific markets e.g. pharmaceuticals
PPP measures
the average cost of a basket of goods across one country w.r.t. another - a cost of living comparison.
RER formula
RER = e = SP* / P
Price of a foreign basket in domestic currency / price of domestic basket in domestic currency.
If e=1
absolute PPP holds: same cost of living abroad and at home.
If e>1
SP* > P
The home basket is undervalued/foreign overvalues.
Cost of living higher abroad compared to at home.
If e<1
SP*<p></p>
If LOOP holds for all goods, does e=1 have to hold? Why/why not?
NO because the domestic and foreign baskets could:
(1) Have different goods
(2) Have different weights for same goods
Difference between absolute and relative PPP formulas
Absolute PPP: e=1 - prices same
Relative PPP: change in e = 0 - prices move together over time, but not necessarily equal.
What does relative PPP mean for the RER?
change in e=0
Therefore RER is constant over time
Logs to show relative PPP
ln(et) = ln(StPt*) - ln(Pt)
ln(StPt*) should move in tandem with ln(Pt) over time.
Does relative PPP hold?
YES - in the long run
NO - in the short run it can be very volatile.
If e decreases, what does this mean for the domestic currency?
e decreases = RER appreciation for the domestic currency
If e increases, what does this mean for the domestic currency?
e increases = RER depreciation for domestic currency.
Test 2 of relative PPP using k period log differences formula. If relative PPP holds…
ln(et) - ln(et-k) = ln(Pt/Pt-k) - ln(Pt/Pt-k) + ln(St/St-k). If relative PPP holds:
ln(Pt/Pt-k) - ln(Pt/Pt-k) = -ln(St/St-k)
Difference between foreign and domestic inflation rates = nominal ER depreciation of foreign currency against domestic.
IF St falls this means:
Require fewer dollars to buy 1 unit of foreign currency = dollar appreciates, but foreign currency depreciates and e falls (if no change in prices.
IF St rises this means:
Require more dollars to buy 1 unit of foreign currency = dollar depreciates, foreign currency appreciates and e rises (if no change in prices)
What SHOULD happen to the nominal ER if foreign inflation > domestic inflation?
If foreign inflation>domestic. e rises: RER depreciation for the dollar, appreciation of foreign currency. To offset this, we need S to fall i.e. foreign currency to depreciate.
What SHOULD happen to the nominal ER if foreign inflation < domestic inflation?
If foreign inflation < domestic, e will fall = RER appreciation for dollar. To offset this, need dollar to decrease in value i.e. increase St.
What does absolute PPP mean?
e=1, StPt* = Pt
One dollar can buy the same basket of goods at home and abroad - same cost of living.
What data do we need to test absolute PPP?
actual price levels Pt and St, not growth rates or indexes.
The big mac index tells us
eBIGMAC = how many US big macs required to buy 1 foreign big mac
eBIGMAC for richer countries than US
e > 1 - cost of living is higher in foreign country, therefore need > 1 US big mac to buy 1 big mac there.
eBIGMAC for poorer countries than US
e < 1 - cost of living is lower in foreign country, therefore need < 1 US big mac to buy 1 big mac there.
Does absolute PPP hold according to big mac index?
NO - e ≠ 1
What does it mean if St < St PPP
StPt* < Pt therefore e<1
This means dollar is overvalued and foreign currency is undervalued. Need St to rise so that foreign currency appreciates against $..
What does it mean if St > St PPP
StPt* > Pt therefore e>1
This means dollar is undervalued and foreign currency is overvalued. Need St to fall to that foreign currency depreciates against $.
Who provides data on actual price levels so we can test absolute PPP for a BASKET of goods?
The International Comparison Programm (ICP)
Established 1960s on recommendation of United Nations Statistical Commission (UNSC)
What is the price level index
e = PLI = SP*/P
Where P* and P are actual price levels and not indices.
Does absolute PPP hold for a basket of goods?
NO it FAILS as ex100 ≠ 100
Why is it useful to compare size of economies using PPP?
Because exchange rates –> overstate size of rich countries, understate size of poor countries. PPP accounts for the fact that a given income can buy more in poorer countries due to lower costs of living.
Why is PPP useful for standard of living comparisons?
Comparing per capita incomes overstates the difference in SOL between rich and poor. Rich countries are systematically more expensive than poor.
Why does absolute PPP fails?
Many goods are NOT traded internationally therefore price discrepancies are NOT arbitraged away through trade.
Cobb-douglas price index for traded and non-traded goods
P = (PT)^1-a (PN)^a
2 assumptions we make
- LOOP holds only for traded goods
2. Price functions are homogeneous of degree 1
RER using price functions and our 2 assumptions
e = [phi(1, PN/PT)] / [phi(1, PN/PT)]
So, absolute PPP holds if:
PN/PT = PN/PT
when is e>1 i.e. RER depreciates for dollar?
When PN/PT > PN/PT
i.e. when the relative price of non-tradables to tradables is higher in the foreign economy than domestic. This means e>1 and the dollar is undervalued.
One reason why relative traded nontraded price could rise for foreign vs domestic.
Productivity growth in the traded sector relative to non-traded sector is faster for the foreign country than domestic.
The Balassa-Samuelson effect =
the tendency for countries with higher productivity growth in tradables compared to non-tradables to have higher prices and thus an appreciates RER.
Production fucntions x2 in Balassa Samuelson model
QT = aT LT
QN = aN LN
Labour is the only input. exogenous labour productivity parameter.
Profit max condition in traded sector
PT aT = W
aT = W/PT
i.e. marginal gain from extra worker = marginal cost in terms of real wage.
Profit max condition in non-traded sector
PN aN = W
aN = W/PN
i.e. marginal gain from extra worker = marginal cost in terms of real wage.
EQUILIBRIUM in Balassa-Samuelson Model
PNaN = PTaT
PN/PT = aT/aN
relative price of non-traded to trade = relative productivities of labour
Take logs and growth rates for equilibrium condition in BS Model
%Change(PN/PT) = %changeaT - %changeaN
Does the BS Model equilibrium condition hold in the data?
Plot growth rate differentials of factor productivities against relative growth of prices for a country. Doesn’t quite follow45 degree line. But positively related using 15-year averages.
RER using BS model equilibrium condition
e = [phi(1, aT/aN)] / [phi(1, aT/aN)]
%changeRER formula using BS model equilibrium condition and Cobb-Douglas price functions.
%change e = alpha[%change(aT/aN) - %change(aT/aN)]
One time the BS model explained RER changes well
German mark depreciated against Italian Lira 1970s/80s.
If e increased, this means %change(aT/aN) should be greater for Italy than Germany = supported by data.
One time the BS model explained RER changes not well
Japanese Yen appreciated against US dollar. Not explained by differences in relative traded-nontraded productivities according to data.
Therefore, the BS model is…
sometimes good as explaining LR changes in RER through differences in relative productivity growth rates, but other times there are alternative explanations not in model.
