4/2/24 Flashcards
LOOP Equation
PCUSD = E$/€ * PCEUR
Law of One Price (LOOP)
Without any natural or artificial barriers to trade, the same good sold in different locations must have the same price when measured in a common currency
Purchasing Power Parity (PPP)
We say that the exchange rate is at PPP if two baskets are the same price when measured in a common currency
PPP equation
PUSD = E$/€ * PEUR
whats the difference between the LOOP and PPP equations?
PPP is for the whole basket and PPP is for individual goods
What is true if LOOP holds for ALL goods in a basket?
PPP hold
Real Exchange rate
The number of baskets of US goods that collectively cosst the same as one basket of European goods
Real Exhchange Rate equation
qUSD/EUR = E$/€ * PEUR/PUS
how much do european goods cost relative to US goods if the Real Exchange Rate is 2?
They are twice as expensive
Spot Exchange rate equation
E$/€=PUSD/PEUR
With Relative PPP, what assumption is formed about the Real Exchange Rate
The Real Exchange Rate is constant
With absolute PPP, what assumption is formed about the Real Exchange Rate
It is constant AND equal to 1
What is the basic idea of the simple monetary model of prices
In the long run, the price level will be proportional to the money supply, where the constant of proportionality might depend on the interest rate
Money Demanded Equation
Md = P * L(i) * Y
Money Market Equilibrium condition
M=PL(i)Y
Real Money Supply
M/P
Real Money Demand
L(i)*Y
Where isReal Income (Y) fixed at and where?
Full Employment Level in Long Run
Deviates in short run
In The long run, what happens when the Money supply changes?
An increase results in higher prices, a decrease results in lower prices. The interest rate doesn’t change
In The short run, what happens when the Money supply changes?
An increase results in lower interest rate, a decrease results in higher interest rate. The price level doesn’t change
expected change in value of foreign currency5
(Ee-E)/E
How are interest rates determined in the short run
Base and foreign monetary policies
What does a temporary change in the money supply do?
The money supply falls by 5% for a few months then returns to its original level. It does NOT change expectaitions about the future.
What does a permanentchange in the money supply do?
the money supply falls by 5% and remains at that lower level permanently
what would tighter monetary policy in the US do to the money market in the US?
interest rates would increase, leading to the value of the dollar to increase and european denominated bonds would decrease in the FX market
Overshooting
The immediate change in the exchange rate due to a permanent change in the money supply will be larger than the lon-run change
L̅
total working population
What are the effects of a permanent reduction in the money supply to the exchange rate?
In the short term, Real Money Supply decreases . And in the Long Run once prices become unstuck exchange rate returns to long run equlibrium (euro depreciates, dollar appreciates). The Exchange rate will ultimaely change and future expectations will change
Why does the Real Money Supply increase when the money supply increases
because the price level is constant
What are the effects of a permanent reduction in the money supply to the fx market?
The expected future value of the euro(foreign currency) will fall, and that implies a reduction in the expected return on euro-denominated bonds.
