Chapter 15
Exchange Rates in the Long Run
The relationship between goods prices and exchange rates is developed in this chapter. After introducing
absolute and relative PPP, examples and real world data illustrating deviations from PPP are used to
motivate a deeper understanding of the link between prices and exchange rates. PPP is used to introduce
“overvalued” and “undervalued” exchange rates. It is important to debate the meaning of such terms in
the context of floating exchange rates. However, at this point in the course it is probably wise to forego
the mention of speculative bubbles and bandwagon effects which could theoretically contribute to the
appearance of an overvalued or undervalued currency.
The chapter includes plots of data on inflation differentials and exchange rate changes as found in IMF
International Financial Statistics. International Economic Conditions published by
the Federal Reserve Bank of St. Louis contains a plot of the last six years data on inflation differentials
Chapter 15 Exchange Rates in the Long Run 59
2009 7.14 4.35 0.95
b. Where was inflation higher (home or overseas) over the sample period?
Inflation is higher at home.
c. How well does relative PPP hold in this example?
60 Husted/Melvin • International Economics, Ninth Edition
2. Suppose that a Big Mac costs $5.00 in New York and SF30 in Geneva. Suppose further that the price
of 1SF on that day is $0.20. Calculate the purchasing power parity exchange rate between the Swiss
franc and the dollar. Based on your calculation, is the SF overvalued or undervalued? Explain.
Suppose now that a Big Mac costs 1.25 pounds in London while the spot rate exchange rate is $2.50.
Is the pound overvalued or undervalued? Explain. Is the Big Mac a good basis for PPP calculations?
Why or why not?
3. Since PPP rarely holds at any point in time, is there any substantive meaning to the terms overvalued
or undervalued currency?
Chapter 15 Exchange Rates in the Long Run 61
4. For what type of goods does the law of one price hold quite well?
5. Suppose that on January 1, the price of one hundred yen was $0.80 and PPP held. Over the year, the
Japanese inflation rate was 5 percent and the U.S. inflation rate was 10 percent. If the exchange rate
at the end of the year was $0.90, does the yen appear to be overvalued, undervalued, or at the PPP
level? Explain your answer.
6. Suppose at the beginning of the year, a textbook book sells for €60 in Paris, France, and $60 in New
York City, and PPP holds. Over the year, there is an inflation rate of 10 percent in France and no
inflation in the United States. What exchange rate would maintain PPP at the end of the year?
7. What is the real exchange rate? What happens to the value of the real exchange rate over time if
absolute PPP always holds? How do changes in the real exchange rate indicate whether currencies are
changing in ways to make a country’s goods more or less competitive?
8. Suppose that economic growth in Mexico suddenly slows, all other things held constant. According to
the monetary approach to exchange rates model, what should happen to the dollar price of the Mexican
peso? Why does the model make this prediction?
62 Husted/Melvin • International Economics, Ninth Edition
9. Consider the monetary approach to exchange rates (MAER) model given in Equation 15.19.
Suppose that each of the domestic hat variables in that equation is growing at exactly the same rate
as its foreign counterpart. What does the MAER model predict will happen to the exchange rate?
Why does the model make this prediction?
10. Suppose that domestic money demand is falling at 2% per year while the money supply is rising at
6% per year. What is happening to the domestic price level? Explain.