Chapter 4: THE THEORY OF PPP AND

THE GENERALIZED MODEL OF

EXCHANGE RATES IN THE LONG-RUN

Nguyen Tien Dung, PhD

Faculty of International Economics,
College of Economics, VNU
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 be sold for the same price in
different markets when prices are expressed in the same
currency.
 Example: A smart phone in Vietnam costs 23 millions VND. The
same smart phone is priced at 1000 USD. Suppose the exchange
rate is 1 USD = 23000 VND. The prices of the smart phone 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
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: Suppose the exchange rate is 23000 VND/USD. The
price of smart phone is 1000 USD in the U.S..What would happen
if the price of the same smart phone is 24 millions VND in
Vietnam?
 Question 2: Suppose the exchange rate is 23000 VND/USD. The
price of a smart phone is 23 millions in Vietnam. What would
happen if the price the same smart phone is 1100 USD in the U.S.?
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:
 Pi = E×Pi*

 E = Pi/Pi*

 Here Pi is the domestic price of a certain good, Pi* 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 establishes the relation between the
domestic price level, the foreign price level and the
exchange rate.
 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 states that the exchange rate must be equal to the ratio of
the domestic and foreign price levels, or the domestic price level is equal to
the foreign price level in absolute terms
P = E×P* or E = P/ P*
here P is the domestic price level; P* is the foreign price level, measured in
terms of foreign currency; and E is the exchange rate (direct quotation).
The price level is the price of all goods and services in an economy. It is
represented by the price of a representative basket of goods and services.
Example: The price of the basket of goods and services 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 dong per dollars.
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.

 Unlike 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

The monetary model consist of three equations: the

PPP theory, the equilibrium condition in the domestic

and foreign money markets.
 The PPP theory establishes the relation between exchange

rate, domestic and foreign price levels. 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.
2. Long-run exchange rate model based on PPP
Monetary model of the exchange rate: equations

Equilibrium condition in domestic money markets:

 P = MS/L(Y,R)

Equilibrium condition in foreign money markets:

 P* = MS*/L(Y*,R*)

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
The monetary model of the exchange rate

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

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
 Unlike an one-time increase in money supply, 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 (Fisher effect)

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 rate leads to an equal 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 evidence 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
rate 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 evidence on the PPP
3. Empirical evidence on the PPP and Law of one price
Changes in VND-USD exchange rate and the inflation differences
(%)
25.0

20.0

15.0

10.0

5.0

0.0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

-5.0

-10.0

Tỷ giá Đồng/đô-la Chênh lệch lạm phát

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.
 Other explanations may include the short-run price stickiness and the
differences in labor productivity.
3. Empirical evidence on the PPP and Law of one price
Trade barriers and transportation costs
Transportation costs and trade barriers create the
differences in the prices 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 markets
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 price levels 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.
Under flexible exchange rates, departures from the
PPP exchange rate are found larger and more
frequently in the short-run.
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 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.
 The real exchange rate is the nominal exchange rate adjusted for
the change in the price levels at home and abroad.
4. The generalized model of the long-run exchange rate
The real exchange rate I
Suppose the price of the reference basket of goods
and services is 1000 dollar in a foreign country and 23
million dongs in Vietnam. The nominal exchange rate
is 23000 dong per dollar.
The real exchange rate between dong and dollar is:
q = (1000*23000)/ 23,000,000 = 1
4. The generalized model of the long-run exchange rate
The real exchange rate II
 Real appreciation: the real appreciation of domestic currency occurs when the
domestic prices rise relative to foreign prices (domestic goods become more
expensive relative to foreign goods).
 q = (E×P*)/P decreases.
 The real appreciation of domestic currency is associated with a fall in the real exchange
rate q.
 Suppose there are no changes in the domestic and foreign price levels and the
nominal exchange rate fall to 22000 dong per dollar. The real exchange rate is:
q = (1000*22000)/23,000,000 = 0.96
 The real exchange rate falls from 1 to 0.96 , implying the real appreciation of
domestic currency.
4. The generalized model of the long-run exchange rate
The real exchange rate II
 Real depreciation: the real depreciation of the domestic currency implies a
decrease in the domestic prices relative to foreign prices (domestic goods
become cheaper relative to foreign goods).
 The real depreciation of domestic currency is associated with an increase in the
real exchange rate q.
 q = (E×P*)/P rises
 Suppose there are no changes in the domestic and foreign price levels and the
nominal exchange rate rises to 24000 dong per dollar. The real exchange rate is:
q = (1000*24000)/23,000,000 = 1.04
 The real exchange rate rises from 1 to 1.04, implying 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 equilibrium real exchange rate depends on the relative
demand for and supply of goods and services 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
relative to foreign 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
Long-term equilibrium real exchange rate:
A relative increase in the demand for domestic product

RS

RD
RD’

A
q1

q2
B

(Y/Y*)
4. The generalized model of the long-run exchange rate
Long-term equilibrium real exchange rate:
A relative increase in the domestic output

 RS RS’
RD

q2

B
A
q1

(Y1/Y1*) (Y2/Y2*)
4. The generalized model of the long-run exchange rate
Real and nominal exchange rates in long-term equilibrium I

The long-run nominal exchange rate depends on the

domestic and foreign price levels, and the 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
 The interest parity condition (UIP):

(Ee-E)/E = R – R*
 From the definition of the real exchange rate, we have:

 (qe-q)/q = (Ee-E)/E - (πe-π*e)

 Where πe and π*e are the expected inflation at home and abroad;
R and R* are the domestic and foreign interest rates; E e and
qe are the expected nominal and real exchange rates; E
and q are the nominal and real exchange rates
5. International Price Differences and Real Exchange Rates
The PPP and UIP
Combing the above equations, the following equality can be
derived:

(qe-q)/q = (R – R*) - (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
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:

r =R–π
e e

r*e = R* – π*e
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
rea depreciation rate of domestic currency.

(qe-q)/q = re – re *