No Such Thing as a Free Lunch: Principles of Economics (Part 182)

Macroeconomic stability will be more elusive and that will affect all of our lives: from the risks many will face in childhood, to the security of employment at working age, to the challenge of accumulating for retirement. More financial instability will introduce more uncertainty all down the line, and that will be a very different world than the one we would have lived in only a couple of decades ago.

Alan M. Taylor

Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates

(Part D)

by

Charles Lamson

Factors that Affect Exchange Rates

Purchasing Power Parity: The Law of One Price If the costs of transporting goods between two countries are small, we would expect the price of the same good in both countries to be roughly the same. The price of basketballs should be roughly the same in Canada and the United States, for example.

It is not hard to see why. If the price of basketballs is cheaper in Canada, it will pay for someone to buy balls in Canada at a low price and sell them in the United States at a higher price. This decreases the supply and pushes up the price in Canada and increases the supply and pushes down the price in the United States. This process should continue as long as the price differential, and therefore the profit of opportunity, persists. For a good with trivial transportation costs we would expect this law of one price to hold. The price of a good should be the same regardless of where we buy it.

If the law of one price held for all goods, and if each country consumed the same market basket of goods, the exchange rate between the two countries would be determined simply by the relative price levels in the two countries. If the price of a basketball were over $10 in the United States and $12 in Canada, then the U.S./Canada exchange rate would have to be $1 U.S. per $1.20 Canadian. If the rate were instead one to one, it would pay people to buy the balls in the United States and sell them in Canada. This would increase the demand for U.S. dollars in Canada, thereby driving up their price in terms of Canadian dollars to $1 U.S. per $1.2 Canadian, at which point no one could make a profit shipping basketballs across international lines, and the process would cease.

The theory that exchange rates will adjust so that the price of similar goods in different countries is the same is known as the purchasing-power-parity theory. According to this theory, if it takes ten times as many Mexican pesos to buy a pound of salt in Mexico as it takes U.S. dollars to buy a pound of salt in the United States, then the equilibrium exchange rate should be 10 pesos per dollar.

In practice, transportation costs for many goods are quite large, and the law of one price does not hold for these goods. (Haircuts are often cited as a good example. The transportation costs for a U.S. resident to get a British haircut are indeed large unless that person is an airline pilot.) Also, many products that are potential substitutes for each other are not precisely identical. For instance, a Rolls-Royce and a Honda are both cars, but there is no reason to expect the exchange rate between the British pound and the yen to be set so that the prices of the two are equalized. In addition, countries consume different market baskets of goods, so we would not expect the aggregate price levels to follow the law of one price. Nevertheless:

A high rate of inflation in one country relative to another puts pressure on the exchange rate between the two countries, and there is a general tendency for the currencies of relatively high-inflation countries to depreciate. 

FIGURE 5

Relative Interest Rates Another factor that influences a country's exchange rate is the level of its interest rate relative to other countries' interest rates. If the interest rate is 6 percent in the United States and 8 percent in Great Britain, people with money to lend have an incentive to buy British securities instead of U.S. securities. Although it is sometimes difficult for individuals in one country to buy securities in another country, it is easy for international banks and investment companies to do so. If the interest rate is lower in the United States than in Britain, there will be a movement of funds out of U.S. securities into British securities as banks and firms move their funds to the higher-yielding securities.

How does a U.S. bank buy British securities? It takes its dollars, buys British pounds, and uses the pounds to buy the British securities. the bank's purchase of pounds drives up the price of pounds in the foreign exchange market. The increased demand for pounds increases the price of the pound (and decreases the price of the dollar). A high interest rate in Britain relative to the interest rate in the United States tends to depreciate the dollar.

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 699-701*

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