Chapter 3: Exchange Rates I: The Monetary Approach in the Long Run

Question 1

Monetary Approach to Exchange Rates

Answer 1

Combination of the monetary theory of price level determination and purchasing power theory of exchange rate determination

Question 2

Law of One Price (LOOP)

Answer 2

Identical goods sold in different locations must sell for the same prices when prices are expressed in a common currency.

E(h/f) = P(h)/P(f)

In the absence of trade frictions (such as transport costs and tariffs), and under the conditions of free competition and price flexibility (where no individual buyers or sellers have power to manipulate prices and prices can freely adjust), identical goods sold in different locations must sell for the same prices when prices are expressed in a common currency.

Question 3

Purchasing Power Parity (PPP)

Answer 3

If the law of one price holds for each good in the basket, it will also hold for the price of the basket as a whole.

q(h/f) = E(h/f)*P(f)/P(h)

If PPP holds, then q should be equal to 1

PPP Implies that the exchange rate at which two currencies trade equals the relative price levels of the two countries

Deviations from PPP come from a number of factors, including transaction costs, nontraded goods, imperfect competition, legal obstacles, and price stickiness.

Question 4

Absolute Purchasing Power Parity (A-PPP)

Answer 4

PPP holds when price levels in two countries are equal when expressed in a common currency

Question 5

Real Exchange Rate

Answer 5

Relative prices of baskets of goods for each country.

q(h/f) = E(h/f)*P(f)/P(h)

Question 6

Real Depreciation

Answer 6

If the real exchange rate rises (more home goods are needed in exchange for foreign goods), then we say that home currency has experienced a real depreciation

Question 7

Real Appreciation

Answer 7

If the real exchange rate falls (fewer home goods are needed in exchange for foreign goods), then we say that home currency has experienced a real appreciation

Question 8

Inflation

Answer 8

The rate of change of price level

Question 9

Relative Purchasing Power Parity (R-PPP)

Answer 9

The rate of depreciation of the nominal exchange rate equals the difference between the inflation rates of the two countries (the inflation differential)
If APPP holds, then RPPP must hold too, but the converse is not necessarily true

Question 10

Three functions of money

Answer 10

1. store of value
2. unit of account
3. medium of exchange

Question 11

Central Bank

Answer 11

A nation’s principal money authority

Question 12

Money Supply

Answer 12

The amount of money that the central bank lets be in the market

Question 13

Money Demand

Answer 13

The demand for money
All else equal, a rise in national dollar income will cause a proportional increase in transactions and, hence, in aggregate money demand

Question 14

Quantity Theory of Money (QTOM)

Answer 14

M(d) = L * PY
Demand for money equals a constant multiplied by nominal income
aka,
M(d)/P = LY
Demand for real money equals a constant times real income

Question 15

Fundamental Equation of the Monetary Model of the Price Level

Answer 15

P(h) = M(h)/L(h)Y(h)
P(f) = M(f)/L(f)Y(f)

Question 16

Fundamental Equation of the Monetary Approach to Exchange Rates

Answer 16

E(h/f) = P(h)/P(f) = (M(h)/M(f)) / ((L(h)Y(h))/(L(f)Y(f))
Exchange rate equals ratio of price levels equals the relative nominal money supplies divided by relative real money demands

Question 17

Hyperinflation

Answer 17

Inflation at a sustained rate of more than 50% per month

Under hyperinflation, PPP holds very well

Question 18

Real Money Demand Function

Answer 18

M(d)/P = LY
Slopes downward to reflect the inverse relationship between the demand for real money balances and the nominal interest rate at a given level of real income Y

Question 19

Real Interest Rate (r)

Answer 19

Inflation rate (pi) minus nominal interest rate (i)

Question 20

Real Interest Parity (RIP)

Answer 20

If PPP and UIP hold, then expected real interest rates are equalized across countries.

Arbitrage in goods and financial markets alone is sufficient, in the long run, to cause the equalization of real interest rates across countries.

Question 21

World real interest rate (r*)

Answer 21

The long-run expected world interest rate

Question 22

Fisher Effect

Answer 22

All else equal, a rise in the expected inflation rate in a country will lead to an equal rise in its nominal interest rate
In the long-run, if inflation rates are unchanged, then the nominal interest rates remain unchanged

Question 23

Nominal Anchors

Answer 23

Policies that work to keep inflation within certain bounds. They attempt to tie down a nominal variable that is potentially under the policy makers’ control.
Since policy makers cannot directly control prices, the attainment of price stability in the short run is not feasible.

Question 24

Monetary Regime

Answer 24

Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability

Question 25

Exchange Rate target

Answer 25

Monetary regime making policy working towards a specific exchange rate

Question 26

Money Supply target

Answer 26

Monetary regime making policy working towards a specific money supply

Question 27

Inflation target and interest rate policy

Answer 27

Fisher suggests that you can target inflation and interest rate instead

Question 28

Central Bank Independence

Answer 28

To avoid political interference, independent central banks are not part of the actual government, but work with the government instead