Ch 16 Flashcards
Law of One Price
Same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important
Purchasing Power Parity (PPP)
application of the law of one price across countries for all goods and services, or for representative groups (“baskets”) of goods and services
Implies E$/€ = Pus/Peu
Two forms of PPP
1) Absolute -> exchange rates = level of relative avg prices across countries
2) Relative -> changes in exchange rates = changes in prices btwn 2 periods (inflation)
Relative PPP Mathematically
(Et - E(t-1))/E(t-1) = πus,t - πeu,t
Monetary Approach to Exchange Rates
uses monetary factors to predict how exchange rates adjust in the long run, based on the absolute version of PPP
levels of average prices across countries adjust so that…
the quantity of real monetary assets supplied will equal the quantity of real monetary assets demanded
P = Ms / L(R,Y)
What does the Monetary Approach to Exchange Rates predict?
The exchange rate is determined in the long run by prices, which are determined by the relative supply and demand of real monetary assets in money markets across countries
Aka: Ms/L -> P -> E
What changes affect money supply/demand so that exchange rates are made to adjust?
1) money supply
2) interest rates
3) output level
From the 3 things that affect exchange rates, explain the effect each has
1) Ms^ -> Pus^ -> E$/€^ -> $v
2) Rus^ -> Lv -> Pus^ -> E$/€^ -> $v
3) Y^ -> L^ -> Pusv -> E$/€v -> $^
A change in the money supply…
Causes a change in the level of average prices
A change in the GROWTH RATE of money supply…
Results in a change of the growth rate of prices (inflation)
Fisher Effect
describes the relationship between nominal interest rates and inflation
R$ - R€ = pi^e us - pi^e eu
Why are price levels lower in poorer countries by the Balassa-Samuelson Theory?
The theory assumes labor productivity is lower in poorer countries for tradable but not for non-tradables. If prices of traded goods = across countries, lower productivity in poor countries implies lower wages, production costs and prices of non-tradables than rich countries.
Why isn’t PPP accurate?
1) Trade barriers + non-tradable products (i.e. haircuts)
2) Imperfect Competition
3) Differences in measure of average prices for goods and services
What is the long run effect of a permanent rise in growth rate of money supply?
An increase in inflation causes the money supply to rise, which leads to higher interest rates, and prices, which increases the exchange rate, and depreciates the dollar.
What is more important to trade - E or q?
q - it considers both prices and exchange rate
Why is the real exchange rate (q) important?
1) shocks in q explain deviations in PPP
2) rise in q leads to rise in exports and less imports (which improves the CA)
When does purchasing power parity hold in the model with real exchange rate?
When Q equals one
What is q?
The number of US baskets one euro basket can buy (E * Peu) / Pus
The real exchange rate approach to exchange rates 
Adds q to the monetary approach model
What is the effect of a rise in output (Y) in the real exchange rate approach model to exchange rates?
It has an ambiguous effect, since we don’t know which will be stronger between an increase in supply (raises q and E) or an increase in demand (lowers q and E) that happen simultaneously when income increases
What are the factors that influence Q?
Money supply and growth rate
Why does an increase in output in the Monetary Approach lead to an increase in monetary demand (which appreciates currency)?
Transactions- increase in output means more jobs, more trips, more action in the economy- people need money!!!
R in the LR vs SR (Paradox)
SR: $ assets look more desirable to hold with higher R so currency appreciates
LR: Change in money growth rate -> change in growth rate of prices (inflation) which decreases demand for real monetary assets and depreciates currency
How does a permanent rise in money supply affect exchange rates in Monetary model?
Increases domestic prices which causes depreciation of currency
Shortcomings of PPP
- Trade costs + non-tradable g+s
- Imperfect competition
- Different baskets
