LE MINH TUAN, Msc

Faculty of International Business & Economics,

VNU University of Economics and Business
Objective
 This lesson analyzes the determination of the
exchange rate in the long-run, taking into account
both monetary and non-monetary factors in the
determination of the exchange rate
Content
 The law of one price and the PPP theory
 The monetary model of the long-run exchange rate
determination
 The empirical evidence on the PPP theory
 The generalized model of the long-run exchange rate
determination
 The international price differences and real interest
parity
1. The Law of One Price and Purchasing Power Parity
Law of one price

 The law of one price: Under the assumption of perfect

competition and if there are no transportation costs and trade
barriers, the same good must sold for the same price in
different markets.
 Example: A T-shirt in Vietnam costs 220000 VND. The same
T-shirt is priced at 10 USD. Suppose the exchange rate is 1
USD = 22000 VND. The prices of the T-shirt in Vietnam and
US are the same when they are measured in the same currency.
1. The Law of One Price and Purchasing Power Parity
Law of one price II

 According to the law of one price, if there are

differences in the prices of the same goods in different
markets, arbitrage will take place and eventually
equalize the prices across markets.
 Question 1: What would happen if the price of the T-
shirt is 240000 VND in Vietnam?
 Question 2: What would happen if the price the T-shirt
is 11 USD in the US?
1. The Law of One Price and Purchasing Power Parity
Law of one price

 The law of one price establishes a relation between

domestic and foreign prices and the exchange rate, as
follows:
P = E×P*
 Here P is the domestic price of a certain good, P* is the foreign price
of the same good, and E is the exchange rate
1. The Law of One Price and Purchasing Power Parity
Purchasing power parity (PPP)
 The PPP theory states that the exchange rate must be equal
to the ratio of the domestic and foreign price levels.
 A decline in the purchasing power of the domestic
currency is associated with a proportional depreciation of
the domestic currency. By contrast, an increase in the
purchasing power of the domestic currency results in a
proportional appreciation of the domestic currency.
 The PPP theory comes in two forms: absolute PPP and
relative PPP.
1. The Law of One Price and Purchasing Power Parity
Absolute PPP theory
 The absolute PPP establishes the relation between domestic price,
foreign price and the exchange rate in the absolute term

 P = E×P* or E = P/ P*

here P is the domestic price level; P* is the foreign price level; and E is the
exchange rate (direct quotation)

 Example: The price of the basket of goods is 23.0 million VND in

Vietnam. The price of the same basket of goods is 1000 USD in the
US. The exchange rate between VND and USD would be 23000.
1. The Law of One Price and Purchasing Power Parity
The relative PPP theory

 The absolute PPP theory does not always hold true in practice
due to the existence of transportation costs and trade barriers

 The relative PPP theory is derived from the absolute PPP. It

asserts that the percentage change in the exchange rate must be
equal to the difference between the percentage changes in the
domestic and foreign price levels.
1. The Law of One Price and Purchasing Power Parity
The relative PPP theory II

 The relative PPP theory can be written as follows:

∆E/E = π-π* or e = π-π*

Here π and π* are domestic and foreign inflation
rates respectively

π = ∆ P/P and π* = ∆P*/P*

1. The Law of One Price and Purchasing Power Parity
The Law of one price and the PPP
 The law of one price and the PPP establish the relation between domestic

prices, foreign prices and the exchange rate, which is brought about by the

arbitrage force.

 Different from the law of one price, the PPP theory applies to the price

level, i.e. the prices of a basket of goods, instead the price of a single

commodity.

 The PPP theory may hold in the reality even if the law of one price fails to

hold for a single commodity.

2. Long-run exchange rate model based on PPP
Monetary approach to the exchange rate

 The monetary model of the exchange rate (flexible

price model) is a combination of the PPP theory and
the theory of money demand and supply.
 The monetary model is based on the assumption of
full employment and the flexibility of prices and
wages, and is a long-run model of the exchange rate
determination.
2. Long-run exchange rate model based on PPP
Monetary model of the exchange rate: equations (I)

 The monetary model consist of three equations: the

PPP theory, the equilibrium condition in the domestic
and foreign money markets

 The PPP: the PPP condition is assumed to hold in the

foreign exchange market

 E = P/P*
2. Long-run exchange rate model based on PPP
Monetary model of the exchange rate: equations (II)

 The domestic and foreign price levels are determined

by the equilibrium condition in the money markets
under the assumption of the standard monetary
demand function.

 P = MS/L(Y,R)

 P* = MS*/L(Y*,R*)
2. Long-run exchange rate model based on PPP
The monetary model of the exchange rate I

 In the monetary model of the exchange rate, the

changes in economic policies or economic
environment lead to the changes in the money supply
and demand, which cause the price levels to adjust to
maintain the equilibrium in money markets. The
exchange rate adjusts in line with the price levels to
maintain the PPP.
2. Long-run exchange rate model based on PPP
The monetary model of the exchange rate II

 The long-run exchange rate is affected by monetary

developments and output:
 The supply of money

 The interest rate

 Output
2. Long-run exchange rate model based on PPP
Ongoing inflation, the interest rate and the PPP

 A continuous rise in the domestic supply of money leads to a

continuous and proportional rise in the domestic price level.

 The ongoing inflation affects public expectation on prices, thus

having an impact on the interest rate.

 If the PPP is held in the long-run, the difference between the

domestic and foreign interest rates will be equal to the difference
between the expected inflation rates at home and abroad.
2. Long-run exchange rate model based on PPP
Ongoing inflation, the interest rate and the PPP

 From the UIP: R = R*+(Ee-E)/E ; and

 From the PPP: (Ee-E)/E = πe – π*e

 We can derive: R - R* = πe – π*e

Here R and R* denote for domestic and foreign interest rates; πe and π*e
are the expected inflation rates at home and abroad
2. Long-run exchange rate model based on PPP
Fisher effect

 The Fisher effect theory establishes a long-run relationship between

inflation and interest rates. It states that, all else equal, an increase in
the expected inflation leads to a proportional rise in the interest rate.
 The relationship between the exchange rate and interest rate differs in
the short-run and long-run. In the short-run, prices are sticky and an
increase in the interest rate is associated with an appreciation of
domestic currency. In the long-run, prices are flexible and an increase
in the interest rate is associated with a higher price level and a
depreciation of domestic currency.
3. Empirical evidence on the PPP and Law of one price
Empirical on the PPP
 The PPP does not explain well the movement of the exchange rate and
the relationship between the exchange rate and price level in the short-
run
 The absolute PPP: the actual exchange rate is very different from the
rate computed from the PPP, particularly in the short-run.
 The relative PPP: the actual changes in the exchange rate and inflation
also differ from that predicted by the PPP, especially in the short-run.
 The relative PPP can perform better the absolute PPP, and it can
explain better the movement of the exchange rate in the long-run. The
PPP also perform better for those countries that have a large trading or
have a geographical proximity.
3. Empirical evidence on the PPP and Law of one price
Empirical on the PPP
3. Empirical evidence on the PPP and Law of one price
Empirical on the PPP
2.5

2.3

2.1

1.9

1.7

1.5 NERI
PPPI
1.3

1.1

0.9

0.7

0.5
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
3. Empirical evidence on the PPP and Law of one price
Explanation for the poor performance of the PPP
 The existence of trade barriers and transportation costs causes a
considerable price divergence between countries.
 The existence of imperfect competition (monopoly and oligopoly),
in combination with trade barriers and transportation costs further
weaken the price links across countries.
 The price levels and inflation are measured using difference baskets
of commodities, making it difficult for a cross-country comparison.
 The price levels cover not only traded goods, but also non-traded
goods, which are irrelevant for the law of one price and the PPP.
3. Empirical evidence on the PPP and Law of one price
Trade barriers and transportation costs

 Transportation costs and trade barriers create the

difference in the price of goods and services between
countries.
 Transportation costs and trade barriers weakens the law of
one price and the PPP theory (particularly the absolute
PPP theory)
3. Empirical evidence on the PPP and Law of one price
Non-traded goods
 Non-traded goods (non-tradables) are those commodities and services
that cannot be traded between countries because of their
characteristics, high transportation costs or trade barriers.
 The prices of non-tradables are determined by the demand and supply
at the home market, and they are not linked to the international price.
 The existence of non-tradables weakens the law of one price and makes
it difficult to compare the price between countries.
 Non-tradables constitute a large proportion in the reference basket of
commodities and have a considerable influence on the overall price
level.
3. Empirical evidence on the PPP and Law of one price
Imperfect competition

 Monopolistic or oligopolistic firms can price

differently in different market
 The differentiated pricing leads to a violation of the
law of one price.
3. Empirical evidence on the PPP and Law of one price
Statistical problems

 The reference basket of goods and services used to

compute the price level varies from countries to
countries, reflecting the difference in consumption
demand between countries.
 These statistical problems create the difficulty in
comparing the price levels and testing the PPP theory.
3. Empirical evidence on the PPP and Law of one price
Other explanations
 Short-run price stickiness: due to the short-run price
rigidity, the departure of the actual exchange rate from
the PPP exchange rate can be larger in the short-run.
 Intervention in the FX market: The violation of the
PPP is found larger and more frequent for those
countries with a fixed exchange rate.
4. The generalized model of the long-run exchange rate
The real exchange rate I
 The real exchange rate is the relative price of goods and
services between countries.
 The real exchange rate is the nominal exchange rate adjusted
for the change in the price levels at home and abroad.
 The real exchange rate are defined as follows:

Q = (E×P*)/P
 P and P* are the price levels at home and abroad; Q and E are the real
and nominal exchange rates respectively.
4. The generalized model of the long-run exchange rate
The real exchange rate I
 Assume that the two economies of Vietnam and the US
produce only a shirt, in which the price of a shirt in Vietnam is
300,000 VND and the price of a shirt in the US is 30 USD,
E(VND/USD) is 20,000, all other things being equal.
 At that time, the price of an American shirt in VND will be
600,000 and twice as expensive as the price of a Vietnamese
shirt. The actual exchange rate in this case will be 2, that is, 2
Vietnamese shirts can be exchanged for one American shirt.
 =>Thus, the competitiveness of the Vietnamese shirt is better
than that of the US shirt in terms of price.
4. The generalized model of the long-run exchange rate
The real exchange rate II
 Real appreciation: An increase in domestic inflation
leads to a fall in the value of domestic currency. The
real exchange rate falls, indicating the appreciation of
domestic currency in real terms.
 Real depreciation: A decrease in domestic inflation
leads to an increase in the real exchange rate,
indicating the real depreciation of domestic currency.
4. The generalized model of the long-run exchange rate
Long-term equilibrium real exchange rate
 The long-term real equilibrium exchange rate depends on the
demand and supply at home and abroad.
 Change in relative demand: a relative increase in the world demand
for domestic goods and services leads to an increase in domestic
prices relative to foreign price) and a real appreciation of domestic
currency.
 Change in relative output supply: an increase in domestic output
leads to a fall in domestic prices and a real depreciation of domestic
currency.

4. The generalized model of the long-run exchange rate
Long-term equilibrium real exchange rate

4. The generalized model of the long-run exchange rate
Real and nominal exchange rates in long-term equilibrium I

 The nominal exchange rate depends not only on the

domestic and foreign price levels, but also on the
change in real exchange rate.

E = Q×(P/P*)
4. The generalized model of the long-run exchange rate
Real and nominal exchange rates in long-term equilibrium I

 Given a level of the real exchange rate, the changes in

money supply and demand affect the nominal
exchange rate as predicted from the monetary theory.
 Non-monetary factors have impacts on the exchange
rate through their impacts on the real exchange rate
4. The generalized model of the long-run exchange rate
The determination of the long-run nominal exchange rate

 Shifts in relative money supply levels: An increase in

domestic money supply leads to a proportional increase in
domestic prices and a proportional depreciation of
domestic currency.
 Shifts in relative money supply growth rates: permanent
increase in the growth rate of domestic money supply
raises domestic inflation and domestic currency
depreciates to the same extent.
4. The generalized model of the long-run exchange rate
The determination of the long-run nominal exchange rate

 Change in relative output demand: An increase in the

world relative demand for domestic goods leads to a real
appreciation of domestic currency, and given the national
price level unchanged, there is also a nominal appreciation
of domestic currency.
 Change in relative output supply: an increase in relative
domestic supply lowers the relative domestic prices and
causes domestic currency to depreciate in real terms. The
impact on nominal exchange rate is ambiguous.
5. International Price Differences and Real Exchange Rates
The PPP and UIP
 Combing the PPP and UIP, the following equality can be
derived:
R – R* = (Qe-Q)/Q + (πe-π*e)
Where πe and π*e are the expected inflation at home and
abroad
 This equality shows that the difference in the interest rates
is equal to the expected real depreciation of domestic
currency plus the difference between the expected
inflation rates at home and abroad.
5. International Price Differences and Real Exchange Rates
The PPP and UIP
 Combing the PPP and UIP, the following equality can be
derived:
R – R* = (Qe-Q)/Q + (πe-π*e)
ex: - The inflation rates of Vietnam and the US are always
at 7% and 2% respectively. The long-term deposit interest
rate in VND and USD does not always have to be 5%
according to the formula RVN – RUS = (πeVN – πeUS) as
discussed.
- If the shifting supply and demand for products causes the
VND to real depreciate against the USD at 1.5% a year, the
interest rate differential between Vietnam and the US is
now 6.5%.
5. International Price Differences and Real Exchange Rates
Real interest parity I
 Real interest rate: the rate of return in terms of
countries‘ output.
 The real interest rate is the nominal interest rate
minus the expected inflation rate:

re = R – πe
5. International Price Differences and Real Exchange Rates
Real interest parity II

 Real interest parity: the difference between domestic

and foreign real interest rate is equal to the expected
real depreciation rate of domestic currency.

r – r* = e
(Q -Q)/Q