Chapter 10: Building Blocks Money Market and Foreign Exchange Rate Flashcards

Question

What factors affect inflation?

Answer 1

1. Excess demand of goods and services - a higher quantity of money supplied implies that people have more funds available to pay for goods and services. 2. Inflationary expectations - If everyone expects the price level to rise in the future, this expectation will increase the rate of inflation today. 3. Raw materials prices - raw materials used in production sold on markets where prices adjust sharply in SR

Answer 2

A permanent increase in a country’s money supply causes a proportional long-run depreciation of its currency. 􏰀 However, the dynamics of the model predict a large depreciation first and a smaller subsequent appreciation. A permanent decrease in a country’s money supply causes a proportional long-run appreciation of its currency. 􏰀 However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation.

Answer 3

The exchange rate is said to overshoot when its immediate response to a change is greater than its long run response Overshooting occur when monetary policy has effect on interest rate but not on prices and expected inflation

Answer 4

The law of one price simply says that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important. P (pen in sg) = E (SGD?MYR) x P (pen in MY)

Answer 5

Purchasing power parity is the application of law of one price across countries for all goods and services for groups of goods and services Implies that exchange rate is determined by relative prices of goods across countries E(SGD/MYR) = P(pen in SG)/ P(pen in MY) (known as absolute PPP)

Answer 6

Absolute PPP: Exchange rate equal changes in relative average price Relative PPP: refers that changes in exchange rates equal to the changes in price between two periods (inflation)

Answer 7

Refer to page 25 of chapter 10 notes

Answer 8

Use formula of absolute ppp: E($/Eur) = P(US)/P(EU) Use formula of money supply = money demand 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.

Answer 9

- increase in money supply M(US) cause proportionate increase in US price level P(US) - cause depreciation in dollar since E(US/EUR) increases

Answer 10

Permanent increase in interest rate lowers aggregate demand. decrease in aggregate demand cause price to increase in US cause depreciation of USD since E(US/EUR) goes up

Answer 11

- increase in output level leads to a rise in US level of production and income - raise US aggregate demand for assets -cause decreasing level of average US prices - cause appreciation of USD

Answer 12

It is more realistic to think that the central bank chooses a growth rate for the money supply and then allow the money supply to grow gradually. 􏰀 A change in the money supply results in a change in the level of average prices. 􏰀 A change in the growth rate of the money supply results in a change in the growth rate of prices (inflation). Continued money supply growth leads to a continuing rise of prices – ongoing inflation.

Answer 13

Since relative PPP holds, can use the interest parity condition together to show that the change in inflation rate can be correlated to the change in interest rate across countries inflation (US) - Inflation (EU) = R (US) - R (EU)

Answer 14

All else equal, a rise in a country’s expected inflation rate will cause an equal rise in the interest rate that deposits of its currency offer. All else equal, a fall in the domestic expected inflation rate will cause a fall in the domestic interest rate.

Answer 15

When US Fed increase growth rate of money supply , this causes an increase in inflation This results in the depreciation of the USD by the same amount as the growth in the money supply

Answer 16

􏰀 Changes in the level of money supply lead to changes in the level of average prices. 􏰀 No inflation is predict to occur in the long run, but only during the transition to the long-run equilibrium. 􏰀 During the transition, inflation causes the nominal interest rate to increase to its long-run value. 􏰀 Expectations of higher domestic inflation cause the expected return on foreign currency deposits to increase, making the domestic currency depreciate before the transition period. 􏰀 The level of average prices does not immediately adjust even if expectations of inflation adjust,

Answer 17

􏰀 The rate of inflation increases permanently when the growth rate of the money supply increases permanently. 􏰀 With persistent domestic inflation (above foreign inflation), the monetary approach also predicts an increase in the domestic nominal interest rate. 􏰀 Expectations of higher domestic inflation cause the expected purchasing power of domestic currency to decrease relative to the expected purchasing power of foreign currency, thereby making the domestic currency depreciate. 􏰀 The level of average prices adjusts with expectations of inflation, ⋆ causing the US dollar to depreciate, but with no overshooting.

Answer 18

little empirical support for absolute PPP, prices of identical basket of goods differ across countries Relative PPP more consistent with data, but also performs poorly to predict exchange rate Reasons for inaccuracy: - trade barriers and non-tradeable products - imperfect competition - differences in measure of average prices

Answer 19

The real exchange rate is the rate of exchange for goods and services across countries. In other words, it is the relative value/price/cost of goods and services across countries. For example, it is the Singapore dollar price of a European group of goods and services relative to the Singapore dollar price of a Singaporean group of goods and services: