Chapter 15

Question 1

Nominal Exchange Rate

Answer 1

The relative price of domestic currency in terms of foreign currency.

The rate at which one person can trade the currency of one country for another.

Question 2

Real Exchange Rate

Answer 2

The relative price of domestic goods in terms of foreign goods.

The rate at which one person trade the goods and services of one country for another.

Question 3

Percentage Change Nominal Exchange Rate

Answer 3

% change in Real Exchange Rate + Foreign Inflation Rate - Domestic Inflation Rate

Question 4

Purchasing Power Parity (PPP)

Answer 4

Goods must sell at the same (currency adjusted) prices in all countries.

The nominal exchange rate adjusts to equalize the cost of a basket of goods across countries because of Arbitrage (-> the law of one price).

The PPP implies that the real exchange rate is equal to 1.

The PPP implies that the nominal exchange rate between two countries equals the ratio of the two countries price levels.

Question 5

Does PPP hold in the real world?

Answer 5

Not always, for two reasons:

1. International arbitrage not possible
   - Non-traded goods
   - Transportation costs
2. Goods of different countries are not perfect substitutes

Nevertheless, PPP is a useful theory

1. simple + intuitive
2. In the real world, nominal exchange rates have a tendency toward their PPP values over the long run.