Chapter 16 - Price Levels and the Exchange Rate in the Long Run Flashcards
What is meant by the long run? What are the implications of the fact that prices are allowed to change?
Long run means a sufficient amount of time for prices of all goods and services to adjust to market conditions so that their markers and the money market are in equilibrium. As prices are allowed to change, they will influence interest rates and exchange rates in the long-run models.
How do neo-classical economists and new-Keynesian economists view prices differently?
Neo-classical economists tend to think that prices adjust relatively quickly, they expect long-run considerations of price adjustment to come into play more quickly. New-Keynesian economists tend to think that prices take longer to adjust, so long-run considerations take longer to come into play, if they come into effect at all.
What is the law of one price?
The law of one price 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. The freer prices are to adjust, the more far-reaching price convergence will be. For durable tradable goods, trade in the goods themselves will lead to price convergence. Even for non-tradables such as services, if the factors of production are mobile, then again we should expect to see price convergence.
What is purchasing power parity? What does PPP assume?
PPP is an economic theory that states that the exchange rate between two countries is equal to the ratio of the currencies’ respective purchasing powers. PPP assumes that in the long-run, it would costs exactly the same to buy a given basket of goods if you bought them in the US using US dollars, or converted the dollars into euros then bought the basket in Europe.
Explain the role of inflation expectations in the monetary approach to exchange rates with PPP. (3)
1) In the monetary approach (with PPP), the rate of inflation increases permanently when the growth rate of the money supply increases permanently. 2) With persistent domestic inflation (above foreign inflation), the monetary approach also predicts an increase in the domestic nominal interest rate. 3) 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.
Explain what happens in the long run model of exchange rates without PPP with regard to changes in inflation expectations. (2)
1) In the long-run model without PPP, the level of average price does not immediately adjust even if expectations of inflation adjust. 2) Causing the exchange rate to overshoot (causing the domestic currency to depreciate more than) its long-run value.
Does PPP hold in practice? (4)
1) There is little empirical support for absolute PPP. 2) The prices of identical commodity baskets, when converted to a single currency, differ substantially across countries. 3) It is necessary to control for the effects of trade frictions. 4) Relative PPP is more consistent with the data, but it also performs poorly to predict exchange rates.
What are the shortcomings of PPP? (5)
Reasons why PPP may not be accurate: the law of one price may not hold because of: 1) Trade barriers 2) Imperfect competition and ‘pricing to market”. 3) Limits to the tradability of goods and especially services. 4) Limits to the mobility of factors, especially limits to immigration. 5) Differences in measures of average prices for baskets of goods and services.
What is the real exchange rate? (3)
1) The real exchange rate is the rate of exchange for goods and services across countries. 2) In other words, it is the relative value/price/cost of goods and services across countries. 3) For example, it is the dollar price of a European group of goods and services relative to the dollar price of an American group of goods and services.
What influences the real exchange rate? (4)
1) A shift in money supply levels. These will affect overall price levels P(US) and P(EU). 2) A shift in money supply growth rates. These will also affect overall price levels, causing inflation and hence ongoing changes in P(US) and P(EU). 3) A change in relative output demand. This will not affect overall price levels. But it will affect relative demand for goods and hence E$/€. 4) A change in relative output supply. Same as 3.
How does an increase in the demand for US products affect the real exchange rate? (2)
What is q?
1) Say that there is an increase in the demand for US products e.g. because Apple produces a new product. This cannot affect P(US) because that is determined by the money market. 2) But, taking P(US) and P(EU) as given, we would expect an increase in the demand for US goods to bring about an appreciation of the dollar: E$/€ falls due to a fall in qUS/EU.
The q term captures the real exchange rate effect.
Derive the relationship of the prices of goods between two different countries according to the law of one price.
What does PPP imply?
Purchasing power parity (PPP) implies that the exchange rate is determined by levels of average prices.
Into what two forms can PPP be differentiated?
What is the monetary approach to exchange rates? (3)
What is the formula for the exchnage rate using the monetary approach?
1) Monetary approach to the exchange rate: uses monetary factors to predict how exchange rates adjust in the long run, based on the absolute version of PPP.
2) It predicts that 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.
3) According to the monetary theory of exchange rates, 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.
What is the Fisher Effect? (2)
Derive the Fisher Effect.
1) The Fisher effect (named affect Irving Fisher) describes the relationship between nominal interest rates and inflation.
2) The Fisher effect: a rise in the domestic inflation rate causes an equal rise in the domestic interest rate in the long run.
Show graphically, the long-run time paths of U.S. economic variables after a permanent increase in the growth rate of the U.S. money supply.
Show graphically, the determination of the long run real exchange rate.
