Chapter 3: Exchange Rates I: The Monetary Approach in the Long Run Flashcards
Monetary Approach to Exchange Rates
Combination of the monetary theory of price level determination and purchasing power theory of exchange rate determination
Law of One Price (LOOP)
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.
Purchasing Power Parity (PPP)
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.
Absolute Purchasing Power Parity (A-PPP)
PPP holds when price levels in two countries are equal when expressed in a common currency
Real Exchange Rate
Relative prices of baskets of goods for each country.
q(h/f) = E(h/f)*P(f)/P(h)
Real Depreciation
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
Real Appreciation
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
Inflation
The rate of change of price level
Relative Purchasing Power Parity (R-PPP)
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
Three functions of money
- store of value
- unit of account
- medium of exchange
Central Bank
A nation’s principal money authority
Money Supply
The amount of money that the central bank lets be in the market
Money Demand
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
Quantity Theory of Money (QTOM)
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
Fundamental Equation of the Monetary Model of the Price Level
P(h) = M(h)/L(h)Y(h) P(f) = M(f)/L(f)Y(f)