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.
