The Price Level and

Exchange Rate
Chapter 5
 What are we going to see in this
chapter?
• The « Law of one price » and the
« Purchasing Power Parity »
• Empirical results of those principles
• The Balassa effect, tradeables and non-
tradeables
• The real exchange rate and the
competitiveness of an economy
• If we have time: the monetary theory of
exchange rates
 1) The Law of One Price and the
Purchasing Power Parity
Definitions:
• In principle, on a competitive market, and if one
neglects transport costs, the prices of a given
good should be equal in two countries
(converted at the current market exchange rate):
Pi = E x Pi* This is called « the Law of One
Price » (LOP)
• The Purchaing Power Parity (PPP) is a theory
according to which the exchange rate between
two currencies is equal to the ratio of the
average prices of a the same basket of goods:
E = P / P* This would be valid in the long run
 More details on LOP and PPP
• There is a difference between LOP and PPP: the
first refers to a particular good whereas the
second refers to a basket of goods and services,
that is to the general price level. PPP may be
true even is LOP is not.
• PPP may be absolute or relative: it is absolute
when it refers to the price levels; it is relative
when it refers to the growth rate of prices
• In the first case, we have E = P/P*; in the
second, we have: ė = π – π* where ė = dLnE/dt
and π are inflation rates = dLnP/dt
 2) Empirical results on PPP
• Is the PPP theory of exchange rates
verified in reality?
• All studies show that both theories
(absolute and relative) are not verified.
The LOP is rarely verified either.
• The most well known example of non
satisfactory test of the PPP theory is the
so-called « Big Mac Index ». We will also
try other tests.
 The Big Mac Index
• This test was invented by the journal «The
Economist» in 1986. It consists in saying that a
convenient «basket» of goods and services
available in many countries is the famous Mac
Donalds hamburger, which is everywhere in the
world totally identical.
• A Big Mac in China costs 10.5 yuan, and in four
American cities it costs 3.10 dollars. Thus, the
exchange rate of the yuan which makes the two
prices equal should be 3.39 yuan to the dollar
• However, the market rate of the yuan is circa 8
yuan to the dollar: consequently, the yuan is
«undervalued» by 58% !
Some prices of the Big Mac in local
currencies and in dollars
• The table below shows in column P the price of the Big Mac in local
currency units, then this same price converted into dollars at the actual rate;
the PPP is calculated dividing P by 3.10. The last column shows wether the
local currency is over (+) or under (-) valued in relation to the dollar

Country currency Price P Price in PPP Actual Over-

US$ rate rate valuation
USA US Dollar 3.10 3.10 1 1 0
Australia Australian $ 3.25 2.44 1.05 1.33 -21
Britain Pound 1.94 3.65 0.62 0.53 +18
China Yuan 10.5 1.31 3.39 8.03 -58
Denmark Danish Kroon 2.75 4.77 8.95 5.82 +54
Eurozone Euro 2.94 3.77 0.95 0.78 +22
Hong Kong Hong Kong $ 12 1.55 3.87 7.75 -50
Malaysia Ringgit 5.50 1.52 1.77 3.63 -51
Singapore Singapore $ 3.60 2.27 1.16 1.59 -27
Switzerlan Swiss franc 6.30 5.21 2.03 1.21 +68
d
Thailand Baht 60 1.56 19.4 38.4 -50
 Another test
• We can also use the Penn World Tables to test
the PPP theory
• The PWT gives for all countries of the world a
ratio of the country’s prices to the price level in
the USA. This ratio may be compared to the
market exchange rate of the country’s currency,
either directly in levels, or in growth rates
(relative PPP)
• As an exercise, you will get these data from
PWT for a sample of 50 countries and you will
draw two graphs: one for the test of the absolute
PPP in 2003, the other for the test of relative
PPP over the period 1990-2003
The reasons why the PPP does not
hold
• There are still many barriers to trade goods over
the world (whether tariffs or transport costs), and
there are also natural barriers to trade services;
as each sold good (including Big Mac) contains
a service component …
• There are still deviations to the competitive ideal
world: products differenciation, market
segmentation, allow LOP gaps
• There are international differences in the
measurement of prices (baskets differ etc)
• But the most important is the « Balassa effect »
3) The Balassa – Samuelson effect
• You may have remarked hat the PPP exchange
rate is undervalued in most developing countries
whereas it is overvalued in richer countries
• This is related to the fact that in general,
services in poor countries are cheaper than in
rich countries
• It is thus possible that, with a dollar income
which is less in a poor country tan in a rich one,
a qualified person may have a standard of living
wich is much higher than his colleague in a rich
country
• This is the so-called Balassa-Samuelson effect.
However, B-S go further and explain why it is so
The Balassa Samuelson conjecture
• The question is : why is the price of non-tradeables
higher in rich countries?
• The answer relies in the productivity differential in the
tradeables sector (B-S, 1964)
• In the manufacturing sector, productivity is lower in poor
countries, thus wages are lower
• But wages in all sectors (incl. services) align themselves
on the wages of the tradeable sector: if wages were
higher in services, people would move away from
manufacturing, labour supply in services would rise and
wages there would decline. If they were lower, the
inverse would take place.
• There is thus an equalisation of wages in all sectors and
the level of wages is determined by the productvity in the
tradeables sector, despite the fact that productivity in
services may be the same in all countries
 Another explanation of the price
differential in services
• Put forward by J. Bhagwati in 1984
• Richer countries are more capitalistic than poor
ones: the ratio K/L (capital output ratio) is lower
in developing countries than in the developed
world
• Services are in general more labour intensive
than manufacturing
• So poor countries will « specialise » in services
which correspond more to their factors
endowment
• Consequently, services in poor countries will
appear cheaper than in rich countries
 An important consequence of the
Balassa-Samuelson effect
• In many emerging countries, productivity in the
manufacturing sector is low, but grows rapidly
• This implies that wages in the tradeable sector also grow
quickly in real terms
• And, according to what we saw, wages in the service
sector follow suit
• As services use mainly labour, their prices will have to
grow, so that they remain profitable
• If prices of tradeables are determined by the world
market – and are thus fixed if the exchange rate is stable
–, prices of non tradeables will have to grow, generating
inflation
• Thus, emerging countries may be bound to a level of
inflation higher than developed economies
 4) The real exchange rate and the
competitiveness of an economy
• Accounting for the above restrictions, PPP
remains valid as a long term determinant of the
exchange rate. Economists use more frequently
the notion of Real Exchange Rate (RER) in
order to assess the competitivity of an economy
• Definition: RER is a synthetic measure of goods
and services prices of one country relative to
others. It is calculated by dividing the nominal
exchange rate by the (relative) price index
• At odds with the PPP, the RER relies not on
identical « baskets » of goods but on local
indexes, calculated with differing baskets
 The calculation of RER
• As for PPP, there are two RER, absloute and relative.
The first one is q = E x P*/P The second one is q^ = e^ +
p*^ - p^ The first formula is used below to represent the
evolution of the RER in Ukraine. P* = +0.2% per month
Nominal exchange rate, price level and real exchange rate
in Ukraine, 1996-2006 (monthly data)

600 200

STRONG DEPRECIATION
500
OF THE HRYVNIA 180
Price index and nominal exchange rate

400 160

Real exchange rate

300 140

200 120

100 100

0 80
6

5
-9

-9

-0

-0

-0
-9

-9

-0

-0

-0
pt

pt

pt
pt

pt

pt

pt

pt

pt

pt
se

se

se

se

se

se

se

se

se

se
Exchange rate Consumer Price index Real Exchange rate
 Use of the RER
• The RER is a good indicator of the
competitiveness of an economy. Or, better, of
the evolution of this competitveness
• If the RER rises, it is said that the currency
depreciates in real terms, meaning that its prices
become more attractve in international markets.
This country becomes more competitive
• If the RER declines, the currency appreciates in
real terms and the country becomes less
competitive
• A country suffering inflation and with a fixed
exchange rate becomes « richer » (in dollars)
but is also losing its competitveness vis-à-vis the
rest of the world
 5) The monetary theory of
exchange rates
• We hane seen that the RER is q = E P*/P
• But wat determines P*/P?
• One theory is that the level of prices in a
country depends on the quantity of money
circulating in this country: the more money
there is, the higher will be the prices
• That idea relies on the theory of money
demand
 Money demand in a nutshell
• Economic agents (households, firms etc) need
money to do their transactions
• But, as detaining money deprives them of gaining
interests on better investments (detaining cash does
not bring any interest at all), they will seek to hold as
little money as possible
• It has been shown that an economic agent will seek
to hold an amount of « real money » which depends
positively of their income and negatively of the
interest rate on bonds
• Md/P = L ( Y+, R-) where Md is the amount of money
sought, P is the price level, R is the interest rate and
Y is the income ; + and – are the signs of the
derivative of L
 The supply of money
• Suppose now that money is emitted in a certain
amount Ms decided by the central bank (that is
true for cash)
• Then, Md will have to adapt to Ms. But so doing,
P, Y and R will have to adapt to the fixing of Ms ;
• Y and R are real variables which depend on
decisions of the economic agents independently
of the money in circulation and of prices
• Thus, we get P = Ms / L : the level of prices
depends on the quantity of money in circulation
 Test of that theory
• You may process yourself a test of this theory:
take a sample of countries in IMF data, and
collect for each of them (a) the amount of money
in circlation in 1970 and in 2000 and (b) the price
level in the same years. Calculate from that the
growth rate of both indicators between the two
dates and plot the results on a graph. What form
do you observe?
• In general, when inflation is high, there is a very
good fit between the amount of money in
circulation and the price level. I represented it on
the following graph for Ukraine
Relation between money supply
and inflation: the case of Ukraine
Hyperinflation et stabilisation en Ukraine 1992-1996

100000

STABILISATION
base 1 en 1990, Echelle logarithmique

10000
Indice des prix à la consommation,

AJUSTEMENT sur les PRIX

RUSSES au PREMIER LIBERATION
TRIMESTRE 1992 DES PRIX
(PRIX MULTIPLIES par 6 en 6% par mois
1000
SYSTEME DES PRIX FIXES

HYPERINFLATION 14% par mois

100
34% par REDUCTION
de la CROISSANCE
de la MASSE
10 MONETAIRE

24% par mois

1
se 2

se 3

se 4

se 5

6
91

92

93

94

95
1

5
93

94

95
92

96
-9

-9

-9

-9
-9
-9

-9

-9

-9

-9
c-
c-

c-

c-

c-
s-

s-

s-

s-

s-
in

in
in

in

in
pt

pt
pt

pt

pt
dé
dé

dé

dé

dé
ar

ar

ar

ar

ar
ju

ju

ju

ju

ju
se

m
Indice des prix à la consommation Billets en circulation
 Back to exchange rates
• Now, if we compare prices between countries
(P*/P), there should be a good chance that this
price ratio follows the ratio of the money
masses.
• If the money supply grows faster in a country,
then its currency should depreciate (relative to a
partner country)
• But we should also take into account Y and R : if
the output Y in a country grows faster, then its
currency should appreciate; and if the interest
rate rises in a country, its currency should
depreciate
 End of the lesson
• Any question?
• Dont forget you have two exercises to do
in this chapter