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

1
Q

Monetary Approach to Exchange Rates

A

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

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2
Q

Law of One Price (LOOP)

A

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.

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3
Q

Purchasing Power Parity (PPP)

A

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.

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4
Q

Absolute Purchasing Power Parity (A-PPP)

A

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

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5
Q

Real Exchange Rate

A

Relative prices of baskets of goods for each country.

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

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6
Q

Real Depreciation

A

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

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7
Q

Real Appreciation

A

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

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8
Q

Inflation

A

The rate of change of price level

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9
Q

Relative Purchasing Power Parity (R-PPP)

A

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

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10
Q

Three functions of money

A
  1. store of value
  2. unit of account
  3. medium of exchange
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11
Q

Central Bank

A

A nation’s principal money authority

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12
Q

Money Supply

A

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

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13
Q

Money Demand

A

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

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14
Q

Quantity Theory of Money (QTOM)

A

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

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15
Q

Fundamental Equation of the Monetary Model of the Price Level

A
P(h) = M(h)/L(h)Y(h)
P(f) = M(f)/L(f)Y(f)
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16
Q

Fundamental Equation of the Monetary Approach to Exchange Rates

A

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

17
Q

Hyperinflation

A

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

Under hyperinflation, PPP holds very well

18
Q

Real Money Demand Function

A

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

19
Q

Real Interest Rate (r)

A

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

20
Q

Real Interest Parity (RIP)

A

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.

21
Q

World real interest rate (r*)

A

The long-run expected world interest rate

22
Q

Fisher Effect

A

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

23
Q

Nominal Anchors

A

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.

24
Q

Monetary Regime

A

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

25
Q

Exchange Rate target

A

Monetary regime making policy working towards a specific exchange rate

26
Q

Money Supply target

A

Monetary regime making policy working towards a specific money supply

27
Q

Inflation target and interest rate policy

A

Fisher suggests that you can target inflation and interest rate instead

28
Q

Central Bank Independence

A

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