Quiz 16: Price Levels and the Exchange Rate in the Long Run


Purchasing power parity ( PPP )is the measure which is used to measure the economic variables in different countries. According to the purchasing power parity condition the goods in an economy should cost the same in another economy after the exchange rates are considered.Relative purchasing power parity relates to the changes in any two economies. The changes that take place in the expected inflation rates to that of the changes in their exchange rates over a period. It predicts that inflation differentials are matched by change in the exchange rate. Given, Inflation rate in country R = 100% Inflation rate in country S = 5% Calculate the inflation differential as follows: img Thus, the inflation differential is img . According to PPP , the ruble should depreciate by approximately 95% against the franc.Under relative PPP , the franc/ruble exchange rate would img with inflation rates of 100 percent in country R and 5 percent in country S. The other way of stating the same is that the franc is expected to appreciate against the ruble by 95%.

Unlike nominal exchange rate which refers to the domestic price of foreign exchange, real exchange rate measures the cost of foreign goods relative to domestic goods. It is the relative price of goods across countries. The real exchange rate denoted as R is defined as img img An increase in R refers to depreciation of the real exchange rate, which means, the relative prices of foreign goods has risen or the relative price of domestic goods has fallen. When the relative price of domestic goods falls, exports become cheaper and thus export demand increases. This will benefit the domestic exporter and thus prospers them. Another reason for increase in foreign demand for exports is the rise in export demand for non-tradable goods also. This also increases the benefits of the exporters. On the other hand, a decrease in R refers to appreciation of the real exchange rate which means the relative prices of domestic goods increases. As a result, exports become expensive and the export demand falls; leading to a loss to the exporters.

(a)Since real exchange rate is the ratio between the prices of tradable goods to non-tradable goods, the change in the composition of total spending towards non-tradable goods affects the real exchange rate. When domestic residents shift their expenditure pattern to buy more of non-tradable goods, the price of non-tradable goods will increase. As a result, there is an increase in the general domestic price level. As a result, the real exchange rate falls that is it appreciates domestic currency against the foreign currency. (b)When people of foreign country demand more goods produced in domestic country, it implies the foreign demand for domestic exports increases. In such case, the domestic prices increases, relative to the foreign price and causes the real exchange rate to fall. As a result, the domestic currency appreciates against the foreign currency.