Chapter 6

Question 1

Real vs. Nominal Exchange Rate

Answer 1

Nominal Exchange Rate (e) = Price of one currency in terms of another

Real Exchange Rate (E) = measure of relative prices of domestic and foreign goods (E = eP/P*)

Question 2

Trade-weighted Real Exchange Rate

Answer 2

Trade-weighted Real Exchange Rate= weighted average of a country’s real exchange rates with weights proportional to level of trade

Question 3

Purchasing Power Parity

Answer 3

Purchasing Power Parity = theory of exchange rates based on the idea that a currency purchases the same quantities of goods and services in different countries

• Implies E is constant over time
• Implies e is a ratio of price levels (e = P*/P)

Law of One Price= theory that an identical good or services has same price in all locations

-In the LR, the % change in a country’s exchange rate is the difference between foreign inflation and domestic inflation