ECON 3580 Lecture Notes - Lecture 9: Imperfect Competition, Price Discrimination

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17 Jul 2018

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The role of inflation and expectations: in the long-run model without ppp, the level of average prices does not immediately adjust even if expectations of inflation adjust, Causing the exchange rate to overshoot (causing the domestic currency to depreciate more than) its long-run value: in the monetary approach (with ppp), the level of average prices adjusts with expectations of inflation, Causing the domestic currency to depreciate, but with no overshooting. Shortcomings of ppp: there is little empirical support for absolute purchasing power parity. The prices of identical commodity baskets, when converted to a single currency, differ substantially across countries: relative ppp is more consistent with data, but it also performs poorly to predict exchange rates. Reasons why ppp may not be accurate: the law of one price may not hold because of: trade barriers and nontradable products, imperfect competition, differences in measures of average prices for baskets of goods and services.

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POINT: Yes. Studies have shown that exchange rate movements are related to inflation differentials in the long run. Based on PPP, the currency of a high-inflation country will depreciate against the dollar. A subsidiary in that country should generate inflated revenue from inflation, which will help offset the adverse exchange effects when its earnings are remitted to the parent. If a firm is focused on long-term performance, the deviations from PPP will offset over time. In some years, the exchange rate effects may exceed the inflation effects, and in other years the inflation effects will exceed the exchange rate effects.

COUNTER-POINT: No. Even if the relationship between inflation and exchange rate effects is consistent, this does not guarantee that the effects on the firm will be offsetting. A subsidiary in a high-inflation country will not necessarily be able to adjust its price level to keep up with the increased costs of doing business there. The effects vary with each MNCs situation. Even if the subsidiary can raise its prices to match the rising costs, there are short-term deviations from PPP. The investors who invest in an MNCs stock may be concerned about short-term deviations from PPP because they will not necessarily hold the stock for the long term. Thus, investors may prefer that firms manage in a manner that reduces the volatility in their performance in short-run and long-run periods.

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ECON 3580 Lecture Notes - Lecture 9: Imperfect Competition, Price Discrimination

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