Slides For Chapter 8 The Real Exchange Rate And Purchasing .
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParitySlides for Chapter 8The Real Exchange Rate andPurchasing Power ParityColumbia UniversityMarch 10, 20211
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityIntroductionYou might have noticed that sometimes Europe seems much cheaperthan the United States and sometimes it is the other way around.The real exchange rate measures how expensive a foreign countryis relative to the home country.The real exchange rate tracks the evolution over time of the priceof a basket of goods abroad in terms of baskets of goods at home.When prices expressed in the same currency are equalized at homeand abroad, we say that purchasing power parity holds.Two important empirical questions: how large and persistent are deviations from purchasing powerparity? what factors determine deviations from purchasing power parity?This chapter is devoted to studying these and other related questions.2
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power Parity8.1 The Law of One Price3
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityWhen a good costs the same abroad and at home, we say that thelaw of one price (LOOP) holds.Formally, the LOOP holds for a given good ifP EP ,whereP domestic-currency price of a particular good in the domesticcountry,P foreign-currency price of the same good in the foreign country,andE the nominal exchange rate (domestic-currency price of one unitof foreign currency).4
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityShould the LOOP hold?In a frictionless world, yes. If a can of coke costs 2 dollars in the USand 5 dollars in Guatemala, you could become infinitely rich buyingcans of coke in the US and selling them in Guatemala.Reasons why the LOOP may not hold: International transportation costs, distribution costs (loading and unloading, domestic transportation, storage, advertising, and retail services).Type of goods for which the LOOP holds pretty well: commodities (e.g., gold, oil, soy beans, wheat), luxury consumer goods(e.g., Rolex watches, Hermes neckties, and Montblanc fountainpens).Type of goods for which the LOOP doesn’t hold well: personalservices (e.g., health care, education, restaurant meals, domesticservices, and personal care, such as haircuts), housing, transportation, and utilities.5
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityThe Big Mac and the LOOPDoes the LOOP hold for Big Macs? This is an interesting casebecause: (1) Big Macs are produced more or less the same way allover the world; (2) prices are readily available. (3) it’s a populargood.The Big Mac real exchange rate: measures how many U.S. BigMacs it takes to buy one Big Mac abroad. Formally,EP BigMac BigMac.e BigMacPwhereeBigMac Big Mac real exchange rate.P BigMac dollar price of a Big Mac in the United States.P BigMac foreign-currency price of a Big Mac in a foreign country.LOOP holds for the Big Mac when eBigMac 1.6
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityTable 8.1: The Big-Mac Real Exchange Rate, January 2019CountrySwitzerlandUnited StatesCanadaEuro areaChinaIndiaRussiaP BigMac 6.505.586.774.0520.90178110.17EEP BigMac .65eBigMac1.1910.910.830.550.460.30E BigMac P P P0.8610.821.380.270.030.057
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityTakeaways from the table The table shows that the law of one price does not hold well forthe Big Mac: Example 1: in Russia a Big Mac sells for the equivalent of 1.65,whereas in the United States it sells for 5.58 1 Big Mac in Russiabuys you only 0.3 Big Macs in the US. That is, the Big Mac realexchange rate is 0.3. Example 2: In Switzerland a Big Mac sells for the equivalent of 6.62. So one Big Mac in Switzerland buys you 1.19 Big Macs inthe US. The Big Mac real exchange rate is 1.19.Why is the Big Mac so expensive in some countries and so cheap inothers? Look at the international tradability of its components:(1) Highly Tradable: grain (wheat and sesame seeds), meat, anddairy (cheese). These components represent a small fraction of thetotal cost of a Big Mac.(2) Hardly Tradable: labor (compare the wage per hour of a shortorder cook in the US vs India), rent, electricity, and water. Largeshare of the cost of a Big Mac.8
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityFigure 8.1: Changes in Big Mac Real Exchange Rates from 2006 to 20190.4Change in the Big Mac real exchange rate: 2006 20190.2URYTHACHN0HKGPHLIDNMYSEGY 0.2LKAUKRRUSSGPAUSCRIJPNPAK AREPOLSAUUSABRAKORNZLCOLCZECANCHLZAFHUNTWNPERARG MEX 0.4EUZSWEGBRCHETUR 0.6DNK 0.8 1 1.2 1.40.4NOR0.60.811.21.41.61.8Big Mac real exchange rate in 200622.22.4 What’s plotted: the change in the Big Mac real exchange rate, eBigMac EP BigMac /P BigMac , between 2006 and 2019 against the Big Mac real exchange ratein 2006 for 40 countries. How to read it: Because, by definition, the Big Mac real exchange rate isalways equal to one for the United States, this country is located at coordinate(1, 0). Countries left of the vertical line were relatively cheaper than the US in2006. Countries below the horizontal line became relatively cheaper than the USbetween 2006 and 2019. Takeaway: most countries were cheaper than the United States in 2006 andmany of them became even cheaper by 2019 (diverged from LOOP).9
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power Parity8.2 Purchasing Power Parity10
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityPurchasing power parity (PPP) is the generalization of the idea ofthe law of one price for broad baskets of goods representative ofhouseholds’ actual consumption, as opposed to a single good.11
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityThe Real Exchange RateThe real exchange rate, denoted e, is defined asEP e .PwhereP domestic-currency price of a a basket of goods in the domesticcountry.P the foreign-currency price of a basket of goods in the foreigncountry. The real exchange rate measures how expensive the foreign countryis relative to the home country: it indicates the relative price of aconsumption basket in the foreign country in terms of consumptionbaskets in the home country. When e 1, we say that absolute purchasing power parityholds.12
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityAbsolute PPP Testing whether absolute PPP holds requires data on the pricesof the domestic basket, P , and the foreign basket, P . Such data is difficult, time consuming, and expensive to collect. The only available data source is the World Bank’s InternationalComparison Program (ICP). About every six years ICP collects pricelevel data of more than 1,000 individual goods for 199 countries. From this raw data, the ICP produces, for each country, an estimate of P and P . Data for the nominal exchange rate, E, isreadily available and thus one can compute e, which allows testingfor absolute PPP.13
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityEmpirical Evidence on Absolute PPPLook at the next table. What’s Shown:— the dollar real exchange rate, e EP /P U S ,— the nominal exchange rate, E (dollar price of one unit of foreigncurrency), and— the PPP exchange rate, E P P P P U S /P . (Ignore this one fornow, we’ll discuss it later.) Notation: The variable P denotes the foreign-currency price ofa basket in the foreign country, and P U S denotes the dollar price ofa basket in the United States. Where, When?: in selected countries in 2011. How To Interpret It?: If absolute PPP held, then a basket ofgoods that costs 100 dollars in the United States should also cost100 dollars in every country. Takeaway: The table suggests that there are large deviationsfrom absolute PPP. For example, a basket that in 2011 cost 100dollars in the United States cost 163 dollars in Switzerland and only27 dollars in Egypt.14
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityTable 8.2: Deviations From Absolute PPP in Selected CountriesCountryeEEP P 1.350.01250.00931United Kingdom1.121.601.43Germany1.081.391.28United States111South Korea0.7711 0.0009023 0.00117China0.540.150.29Vietnam0.334.88e-05 istan0.280.010.04Egypt0.270.170.62Notes. Authors calculations based on data from “Purchasing Power Parities andReal Expenditures of World Economies, Summary of Results and Findings of the2011 International Comparison Program,” Table 6.1, The World Bank, 2014.15
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityHow does the ICP real exchange rate compare with the Big Macreal exchange rate?This is shown in the graph on the next slide with plots e againsteBigMac.16
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityFigure 8.2: Comparing the ICP and Big-Mac Real Exchange Rates in 20111.845 degree line CHE1.6AUS1.4ICP real exchange 0.40.60.811.21.41.6Big Mac real exchange rate1.822.22.4 What’s Shown: the World Bank’s International Comparison Program (ICP)real exchange rate (RER) against The Economist’s Big-Mac real exchange ratefor 57 countries in 2011. Interpretation:the Big-Mac real exchange rate is highly correlated (0.81)with its ICP counterpart. Takeaway: the Big Mac real exchange rate is a good proxy measure of howexpensive different countries are relative to one another. Why is this relevant: The ICP RER is difficult and costly to construct andis produced only every 6 years. The Big Mac RER is easy to construct and isproduced at least once a year by The Economist.17
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power Parity8.3 PPP Exchange Rates18
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityDefinitionThe PPP exchange rate is the nominal exchange rate that wouldmake the consumption basket in two countries equally expensive.Formally, letting E P P P denote the PPP exchange rate, we have thatE P P P P P,P price level in the domestic countryP price level in the foreign country.If E P P P E the domestic country is more expensive than theforeign country (P EP ) and we say that the foreign currency isundervalued.If E P P P E the domestic country is less expensive than theforeign country (P EP ) and we say that the foreign currency isovervalued.19
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityBig Mac PPP Exchange RatesFollowing the above definition, is it is given byP BigMac U SBigMacPPPE .BigMac PTake another look at Table 8.1 from slide 7, which shows the BigMac PPP exchange rate and is reproduced on the next slide. for Switzerland E BigMac P P P E Switzerland is more expensivethan the US, and the Swiss franc is overvalued relative to the dollar. for India E BigMac P P P E India is cheaper than the US, and theIndian rupee is undervalued relative to the dollar.20
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityTable 8.1: The Big-Mac Real Exchange Rate, January 2019CountrySwitzerlandUnited StatesCanadaEuro areaChinaIndiaRussiaP BigMac 6.505.586.774.0520.90178110.17EEP BigMac .65eBigMac1.1910.910.830.550.460.30E BigMac P P P0.8610.821.380.270.030.0521
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityDoes China Manipulate Its Currency to Gain Competitiveness? A number of policymakers and observers have suggested that Chinahas put in place policies conducive to an undervaluation of its currency with the intention to boost China’s competitiveness in international trade. The table shows that E BigMac P P P for China is 0.27 dollar per yuan,while the market exchange rate, E, is 0.15 dollar per yuan. Thismeans that, according to the Big Mac PPP exchange rate, the yuanis undervalued relative to the dollar. This gives credence to thecritics. But later we will argue that if we take into account the differentlevels of economic development in the US and China, this conclusionis far less clear.22
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityPPP Exchange Rates for Baskets of GoodsCountrySwitzerlandUnited StatesChinaIndiaEgypte1.6310.540.320.27EEP P P1.13 0.69110.15 0.290.02 0.070.17 0.62This table shows an excerpt from Table 8.2 presented on slide 15 earlier.The last column displays PPP exchange rates.PPP exchange rates are constructed using the price level data (P ) from the 2011ICP program for baskets of goods, which contain hundreds of goods. Takeaways: Similar pattern of under- and over-valuation of currencies as suggested by the Big Mac PPP exchange rates: In particular– the Swiss franc is overvalued and– the Indian rupee and Chinese yuan are significantly undervalued.23
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power Parity8.3.1 PPP Exchange Rates and Standard of Living ComparisonsStandard of Living Comparison are Tricky The problem is that prices of similar goods vary widely acrossborders. Example: in 2011 GDP per capita was 49,782 dollars in the UnitedStates but only 1,533 dollars in India. Can we conclude that theaverage American is 32 times richer than the average Indian? Whatif a given amount of dollars buys more goods and services in Indiathan in the United States? Let’s calculate how many burgers one can buy with each per capitaGDP: A Big Mac costs 5.58 dollars in the United States but only2.55 dollars in India. So one U.S. per capita GDP buys 8,922 BigMacs and one Indian per capita GDP buys 601 Big Macs. Thus, interms of Big Macs, Americans are 15 times richer than Indians. Still a big income gap, but not as large as the one suggested bythe simple ratio of dollar GDPs.24
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityPer Capita GDP at PPP Exchange Rate Now compare GDPsper capita measured in units of baskets of goods. LetGDP I GDP per capita in India in Indian rupees.P I the rupee price of one basket of goods in India. GDP I /P I per capita GDP in India in units of baskets of goods.Similarly, let GDP U S and P U S be GDP in the United States and theprice of one basket of goods in the United States, both measuredin dollars. GDP U S /P U S per capita GDP in the United States measured inunits of baskets of goods.GDP U S /P U S Ratio of Incomes in Baskets of Goods GDP I /P IGDP U S1 P U S /P I GDP IGDP U S .PPP,IIEGDPE P P P,I GDP I is called per capita GDP at P P P exchange rate; it’sdenoted GDP P P P,I and represents per capita GDP in India whenbaskets of goods are priced in dollar prices of the United States.25
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityLook at the Next TableIt shows GDP per capita in dollars at market exchange rates and atPPP exchange rates.26
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityTable 8.3: GDP Per Capita at Market and PPP Exchange Rates in 2011CountryNorwaySwitzerlandAustraliaUnited StatesJapanGermanyUnited KingdomSouth 15331255874GDPPPPGDP U .1217.2432.2632.4739.6856.95GDP U SGDP P P .1917.7827
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityIn India, GDP per capita was 1,533 dollars when measured at marketexchange rates but 4,735 dollars when measured at PPP exchangerates.per capita GDP in the United States in 2011 was 49,782 dollars. the average American is 32 times as rich as the average Indianwhen GDP is converted into dollars at market exchange rates, but11 times as rich when GDP is converted at PPP exchange rates. This shows that on average prices in India are lower than in theUnited States.Is this a more general pattern? Are poor countries cheaper than richcountries? Look at the next graph.28
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power Parity8.3.2 Rich Countries are More Expensive than Poor CountriesFigure 8.3: Higher Prices in Rich Countries1.8Switzerland1.61.4Real exchange rate, 2011Japan1.2GermanyUnited iEthiopia0.2500India2000800032000GDP per capita at market exchange rates, 2011, log scale128000 What’s shown? the dollar real exchange rate, e EP /P U S , against per capitaGDP at market exchange rates in 2011 for 177 countries. Takeaway: countries with higher per capita incomes tend to be more expensive. Note: China is not an outlier casting doubt on the claim that the yuan ismanipulated.29
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power Parity8.4 Relative Purchasing Power Parity30
Schmitt-Grohé, Uribe, Woodford “International Macroeconomics”Slides for Chapter 8: The Real Exchange Rate and Purchasing Power ParityRelative Purchasing Power Parity Most studies of purchasing power parity focus on changes in thereal exchange rate, rather than on its level. Why? To calculate the change in the real exchange rate, one canuse Consumer Price Indices, which are readily available for manycountries at a relatively high frequency (typically monthly). The consumer price index does not provide information about theprice of a basket of goods, but about its change.Et Pt 0,relative PPP holds if et Ptwhere et real exchange rate at time t, Et nominal exchange rateat time t, Pt, and Pt domestic and foreign consumer price indicesat time t, and change over time. When et 0 we say that the real exchange appreciates. Thedomestic country becomes more expensive. When et 0 we say that the real exch
— the nominal exchange rate, E (dollar price of one unit of foreign currency), and — the PPP exchange rate, EPPP PUS/P . (Ignore this one for now, we’ll discuss it later.) Notation: The variable P denotes the foreign-currency price of a basket in the foreign country, and PUS denotes the do
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Part One: Heir of Ash Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 Chapter 20 Chapter 21 Chapter 22 Chapter 23 Chapter 24 Chapter 25 Chapter 26 Chapter 27 Chapter 28 Chapter 29 Chapter 30 .
