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Lecture 13

# MGEB06H3 Lecture Notes - Lecture 13: Gdp Deflator, Purchasing Power Parity, Customs Broking

Department
Economics for Management Studies
Course Code
MGEB06H3
Professor
Iris Au
Lecture
13

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1 | P a g e
Purchasing Power Parity (PPP) Measuring Variables
Absolute PPP
This theory says (predicts) the real exchange rate is equal to one (unity or parity) in
the long-run.
So
1
f
P
Pe
Where ε = the real exchange rate
= # of units of foreign real GDP you can buy per domestic unit of real GDP
e = the nominal exchange rate
= # of units of foreign currency you can buy per domestic unit of currency
P = the domestic GDP deflator
Pf = the foreign GDP deflator
Assumes:
1) We are studying the long-run
2) There is enough openness to international trade & financial capital flows
(having perfect financial capital mobility will give this)
3) Governments do not exert much control over the price level and/or the
nominal exchange rate (so that the real exchange rate is “flexible” enough in
the long-run to achieve whatever level the economy feels is necessary)
4) Output in both countries is identical (i.e. perfect substitutes) this makes a
real exchange rate of 1 sensible (if other favourable conditions described
below also hold)
5) All goods & services are tradable internationally (this ensures that domestic
& foreign prices are driven to equality, nominal exchange rate adjusted, if
other favourable conditions described below also hold)
6) There are no transportation costs
7) There are no transactions costs (i.e. there are no trade frictions such as
tariffs, different languages of business, customs brokerage fees, costs of red
tape, currency exchange fees etc.)
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2 | P a g e
Relative PPP
This theory says (predicts) the real exchange rate is constant in the long-run.
So
f
P
Pe
some constant (which may be 1, but need not be 1)
Assumes:
1) , 2) & 3) (above)
Absolute PPP implies relative PPP (i.e. if absolute PPP holds then so does
relative PPP since 1 is a constant). But the reverse is not necessarily true, relative
PPP can hold while absolute PPP does not (i.e. when the real exchange rate is
constant in the long-run but not equal to one).
If the real exchange rate is constant then its percentage rate of change is zero. So,
f
f
P
P
P
P
e
e
0
)(
f
f
f
P
P
P
P
e
e
That is, in the long-run and very long-run, the nominal exchange rate is moving
around by exactly enough to offset the changes in the domestic and foreign prices
levels and keep the real exchange rate constant.
Aside:
One of the so-called “fundamentals” of the nominal exchange rate is a (relatively)
low rate of domestic inflation. If our nation has a lower rate of inflation than the
foreign economy then the nominal exchange rate will be appreciating (at a rate
equal to the gap between the foreign inflation rate and our rate of inflation. But the
real exchange rate will not be appreciating (or depreciating). It will be remaining
constant in the long-run. This is an example of the Classical dichotomy the
separation between the real economy and the nominal economy in the long-run.
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find more resources at oneclass.com