chap 3 Flashcards
What is loop?
Identical goods must be sell for the same price when prices are express in common currency
a state in absence of trade friction , free competition and price flexibility
what is PPP (Purchase power parity )?
- macro economic counter part of loop
- it is relative to a basket of goods (not individual - loop)
what is the real exchange rate?
the relative price of basket relative with one country to another
(it tell us how many US basket are need to buy EU basket )
new terminology: real depreciation and real appreciation
what is the difference of exchange rate and real ER compare to currencies?
For currencies the real exchange rate is REAL CONCEPT
The exchange rate is nominal
Absolute PPP and Real exchange rate
PPP states that Real ER rate = 1
new terminology : undervalued , overvalued
Absolute PPP and the nominal exchange rate
Purchasing power parity implies that the exchange rate at which two currencies trade equals the relative price levels of the two countries
what is the relative PPP?
it is the rate of depreciation of the nominal exchange rate equals the difference between the inflation rates of 2 countries
^E($/e) = ( inflation US) - (Inflation - EU)
^E($/e) is rate of depreciation of nominal ER
( inflation US) - (Inflation - EU) is inflation differential
what explain deviations in the PPP?
translations cost
non traded goods
imperfect competition and legal obstacles
stickiness price
for how long the PPP deviations last ? (usually )
it is called: 4 - year half life
-rule of thumbs as guide to forecasting real exchanges rates
what is money ?
- store of value
- unit of account
- medium of exchange
what determines the price levels of countries?
In the long run, by relative demand and supply of money
Formula Quantity theory of money
demand for money = constant + nominal income
Formula Demand for real money balances:
Demand for real money = constant + real income
Formula of equilibrium ion the money market
Money supply (M) = nominal demand for money
(L x P x Y )
Y: real income
P: price level
L: constant
Real money supply (M/P) = real money demand (L x Y )
the rate in hyperinflation :
inflation rise more than 50% per month
Most important failure of PPP :
Hyperinflation
what is P x Y in the general model for demand for money:
Nominal income (P x Y )
P: price level
Y : real income
what is Md/P in the general model for demand for money:
demand for real money
M: money demand
P: price level
what is M/P in the long run equilibrium ?
Real money supply
M: money suplly
P: price level
what is the fisher effect ?
A rise in the inflation rate in a country will lead to an equal rise in its nominal interest rate
nominal interest rate differential = nominal inflation rate differential (expected )
what is real interest parity ?
when the PPP and UIP ( LOOP + ER ) hold, then expected real interest rate are equal across countries
what is UIP ?
- It is uncovered interest rate parity
LOOP + ER
loop: law of one price
ER : exchange rate
what is L x Y in the general model?
it is Relative real money demand (L x Y)
General model : (all equations)
ER = Ratio price levels (Pu/Pe) = Relative nominal money supply / relative real money demand
Relative money supply formula :
Mus / Meu
divide the money supply of 2 countries
Relative real money demand :
Lus x Yus / Leu x Yeu
divide the real money demand of 2 countries
formula fisher effect
I $ - I e = e. pi us - e pi eu
I $ - I e , mean nominal interest rate
e. pi us - e pi eu, mean nominal inflation rate
e. pi: expected inflation
nominal interest rate = nominal inflation rate (expected)
how many nominal anchor exist ? and name
- ER target
- Inflation target + interest parity rate policy
- Money supply target
what is the ER Target ? (nominal anchor)
It is a policy focus in achieving an inflation target through manipulation of the exchange rate
( rate of depreciation is the anchor)
what is the ER target formula ?
Inflation = rate of depreciation + foreign inflation
pi h = ( ^ E (h/f) // E (h/f) ) + pi f
pi h : home inflation
pi f : foreign inflation
E (h/f) : ER
^ E (h/f): Relative ER (average)
what is the money supply target ?
It is a policy to control inflation through manipulation of the money supply
(the anchor is the money supply growth)
what is the money supply target formula?
inflation = money supply growth - Real output growth
what is the inflation target + interest parity rate policy?
It is a policy to control inflation through manipulation of the interest rate (global and individual )
(the anchor variable is the nominal interest rate)
what is the formula for inflation target + interest parity rate policy?
Expected inflation = nominal interest rate - world real interest rate
what is a monetary regime ?
Long run nominal anchoring and short run flexibility
when the PPP is weak ?
in the short run : deviations in the ER
and failure is :
- market friction
- imperfections that limit arbitrage
- price stickiness
what explains the quantity theory ? (or simple monetary model>?
Price levels in terms of money supply and Real income
and PPP explains ER in terms of price levels
the combination develop a monetary approach to ER
PPP + uncovered interest parity
strong implications of the FISHER EFFECT
fisher effect summary:
Local inflation rate influence nominal interest rate
therefore, interest rate should be equalizer ( at least in the long run )
