Price Levels and the Exchange

Price Levels and the Exchange
Rate in the Long Run
At the end of 1970, you could have bought 358 Japanese yen with a single
American dollar; by Christmas 1980 a dollar was worth only 203 yen.
Despite a temporary comeback during the 1980s, the dollar’s price in yen
slumped to 80 by the autumn of 2010. Many investors found these price changes
difficult to predict, and as a result fortunes were lost—and made—in the foreign
exchange market. What economic forces lie behind such dramatic long-term
movements in exchange rates?
We have seen that exchange rates are determined by interest rates and expectations
about the future, which are, in turn, influenced by conditions in national
money markets. To understand fully long-term exchange rate movements, however,
we have to extend our model in two directions. First, we must complete our
account of the linkages among monetary policies, inflation, interest rates, and
exchange rates. Second, we must examine factors other than money supplies and
demands—for example, demand shifts in markets for goods and services—that
also can have sustained effects on exchange rates.
The model of long-run exchange rate behavior that we develop in this
chapter provides the framework that actors in asset markets use to forecast
future exchange rates. Because the expectations of these agents influence
exchange rates immediately, however, predictions about long-run movements
in exchange rates are important even in the short run. We therefore
will draw heavily on this chapter’s conclusions when we begin our study in
Chapter 17 of short-run interactions between exchange rates and output.
In the long run, national price levels play a key role in determining both
interest rates and the relative prices at which countries’ products are traded.
A theory of how national price levels interact with exchange rates is thus central
to understanding why exchange rates can change dramatically over periods
of several years. We begin our analysis by discussing the theory of
purchasing power parity (PPP), which explains movements in the exchange
rate between two countries’ currencies by changes in the countries’ price levels.
Next, we examine reasons why PPP may fail to give accurate long-run predictions
and show how the theory must sometimes be modified to account for
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 385
supply or demand shifts in countries’ output markets. Finally, we look at what
our extended PPP theory predicts about how changes in money and output
markets affect exchange and interest rates.
LEARNING GOALS
After reading this chapter, you will be able to:
• Explain the purchasing power parity theory of exchange rates and the
theory’s relationship to international goods-market integration.
• Describe how monetary factors such as ongoing price level inflation affect
exchange rates in the long run.
• Discuss the concept of the real exchange rate.
• Understand factors that affect real exchange rates and relative currency
prices in the long run.
• Explain the relationship between international real interest rate differences
and expected changes in real exchange rates.