SC - Exchange rates--OOP

[david friedman]

At 7:02 AM -0500 11/18/98, Brenna wrote:

>Besides, the cost of living
>does not increase or decrease every time the exchange rate does....it is based
>more on the stock market, gold prices, and government gold holdings than the
>money all of us take home everyday.

The technical term for the issue  raised here is "purchasing power parity."
In the long term, exchange rates are based on the cost of goods that are
imported or exported. If, at current exchange rates, all of the goods that
move in international trade are cheaper in the UK than in the US, then
Americans will want to buy pounds with dollars in order to import goods
from the UK, nobody in Britain will want to sell pounds for dollars, since
nothing in the US will be worth importing, so the demand for pounds (in
exchange for dollars) will be higher than the supply, so the price of the
pound (measured in dollars--i.e. the exchange rate) will rise. It will
continue rising until the number of pounds people want to buy for dollars
equals the number of pounds people want to sell for dollars--i.e. the
exchange rate is at equilibrium.

If relative prices of all goods in the US were the same as in the UK, the
result would be an exchange rate at which all prices were the same in both
countries, and there would be no trade. But relative prices are different
in different countries, so you end up with an exchange rate at which the
things the UK is relatively good at producing are cheaper in the UK--and so
get exported to the US--and vice versa for the things the US is relatively
good at producing.

You get large deviation from purchasing power parity if the good one
country is particularly good at producing happen to be goods that don't
move in international trade--housing, domestic service, restaurant food,
....  . An exchange rate which makes the price of goods that move in
international trade about the same between the two countries--higher for
some lower for others--leaves the cost of the non-trading costs much lower
in one country than the other, with the result that the exchange rate gives
a bad picture of relative costs for such goods.

In the short run, there are additional factors, and I have ignored capital
flows (some of the things people want to exchange money in order to buy may
be land or shares of stock, not goods that get physically exported) but the
above is a reasonably accurate description of the long run picture.


David/Cariadoc
http://www.best.com/~ddfr/


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