Chapter 6 Part 2

Question 1

Explain the two types of exchange rates

Answer 1

Nominal Exchange Rate: The Exchange rate between the two currencies
Real Exchange Rate: The exchange rate between two goods
Also called the terms of trade

Question 2

What is the definition of nominal exchange rate?

Answer 2

Nominal Exchange Rate: Nominal Exchange Rate is the relative price of the domestic currency in terms of foreign currency, e
It measures how many units of foreign currency can be bought by one unit of domestic currency

Question 3

What do we always express the nominal exchange rate, e, as? What is Nominal Depreciation? What is Nominal Appreciation?

Answer 3

We always express the nominal exchange rate,e, in units of foreign currency per one unit of domestic currency (Canadian dollar here)

Nominal Depreciation: If the domestic currency picks fewer units of foreign currency: e down
e = 100 yen/$ -> e = 90 yen/$ (depreciation of the $ or weaker$

Nominal Appreciation: if the domestic currency picks more units of foreign currency: e up
e = 100 yen/$ -> e = 110 yen/$ (appreciation of the $ or stronger $)

Depreciation of the $ -> Appreciation of Yen
Appreciation of the $ -> Depreciation of Yen

Question 4

What is the definition of real exchange rate?

Answer 4

Real Exchange rate is the relative price of domestic goods in terms of foreign goods, e

Question 5

With real exchange rate how do we make prices comparable?

Answer 5

E = e * P / P*, making prices comparable: numerator

Question 6

What do we always express the real exchange rate, e, as? What is Real Depreciation? What is Real Appreciation?

Answer 6

We always express the real exchange rate,e, in units of foreign goods per domestic good (Canadian goods here)
Real Depreciation: If the domestic goods become cheaper, or foreign goods become relatively more expensive: E down
Real Appreciation: If the domestic goods become relatively more expensive or foreign goods relatively become cheaper

Question 7

What is the formula for the macro model, E, and what does each term represent and why?

Answer 7

In reality the countries produce a variety of goods, so E represents the relative price of a basket of domestic goods in terms of a basket of foreign goods
In our macro model, E, represents the relative price of the single domestic good, Y, in terms of the single foreign good Y*
E = e * P / P*
E is the real exchange rate
e is the nominal exchange rate
P is the domestic GDP deflator
P* is the foreign GDP deflator

Question 8

What is the relation between net export and the real exchange rate?

Answer 8

NX = NX(E_): The net export function reflects a negative relation between net export and real exchange rate:
Because if E rises:
The Canadian goods become more expensive relative to foreign goods
Export falls, imports rises
Net export falls

Question 9

Real Exchange Rate and Net Exports: When is there a trade deficit or trade surplus in the net export function? Describe both scenarios.

Answer 9

NX = NX(E_)
If E = E2:
Canadian goods are too expensive
Low export, high import
Trade deficit
If E = E1
Canadian goods are too cheap
High exports, low imports
Trade Surplus

Question 10

How is the Real Exchange Rate E determined in the long run

Answer 10

We just observed that the net export is negatively related to the real exchange rate
Long Run Equilibrium in the goods market: Sbar = Ybar - C(Ybar - Tbar) - Gbar
Small Open Economy with perfect capital mobility r = r: I =I(r)
In the first chapter, we showed that at the net export is always equal to net capital outflow (identity ): NX = S - I
NX(E) = Ybar - C(Ybar - Tbar) - Gbar - I (r*_)
In the long run national saving, S, is fixed, given technology, production factors, fiscal policies
Net export is negatively related to the real exchange rate
E adjusts such that the net export, NX is equal to net capital outflow, S - I -> NX = S-I

Question 11

For the Foreign Exchange Market Graph Draw it. Explain both the supply and demand side

Answer 11

Net capital outflow is the supply of domestic currency denominated funds by domestic residents who want to buy foreign assets (invest abroad)
Net export is the foreigners demand for domestic denominated funds to buy domestic goods

Question 12

In the Foriegn Exchange Market, What happens with E1 and E2 draw the graphs

Answer 12

S-I > NX
Supply of domestic currency is more than demand for it
Real depreciation, E down
Cheaper Domestic Goods
NX rises

Question 13

Fiscal Policies and Exchange Rate: What is the impact of an expansionary fiscal policy, G up?

Answer 13

Public Savings Fall
National Savings Fall
Net Capital Outflow Fall
Supply of dollar in the exchange market falls
Real appreciation, E up
Domestic goods becomes relatively more expensive
Exports falls, imports rise
Net Exports falls

Question 14

Fiscal Policies and Exchange Rate: What is the impact of an increase in the world interest rate r*?

Answer 14

Investment falls
Net Capital Outflow rises
Supply of dollar in exchange market rises
Real depreciation
Canadian goods becomes cheaper, relatively
Export rises, import falls
Net Export rises

Question 15

How is the nominal interest rate, e, determined in the long run?

Answer 15

Recall: E = e * P / P*
e = E * P/P
Change/e = changeE/E + Pie - Pie
The depreciation rate, E is determined by the quality of net exports and net capital outflow, inflation rates are depending on monetary policies
For any given value of E, the growth rate of e equals the difference between foreign and domestic inflation rate

Question 16

What is the Law of One Price? What is Arbitrage?

Answer 16

Identical Products must sell at the same price in different countries when prices are expressed in the same currency if;
Markets are competitive
No transportation costs
No official barriers to trade (tariffs, quotas,….)
Arbitrage: Buying low, selling high
Higher demand for wheat in Canada, higher Supply in UK
Price of wheat rises in Canada falls in UK, Canadian $ may also appreciate
Or Canadian $ may appreciate as demand for it rises

Question 17

What is the Purchasing Power Parity (PPP):

Answer 17

PPP is the application of the law on price across the countries, for all goods and services or a reference basket of goods and services
This means, if the international arbitrage is possible, all countries have the same price levels, when prices expressed in terms of the same currency
The currencies of all countries should have the same purchasing power everywhere

Question 18

What happens if purchasing power holds? What are the 2 conditions?

Answer 18

Changes in saving and investment (so net capital outflow) do not affect the nominal and real exchange rate
Changes in the nominal exchange rate are only due to price levels
Recall: E = e * P / P* = 1 -> e * P = P*
Cost of a basket of domestic goods in foreign currency
Cost of a basket of domestic goods in domestic currency
ePPP = P* / P
The nominal exchange rate adjusts to equalize the cost of a basket of goods across countries

Question 19

How does the PPP theory not describe the the real world perfectly?

Answer 19

Imperfect substitutability of goods: some consumers may prefer the Japanese cars European cars
Market power leads to price discrimination. Firms sell the same product for different prices in different markets and different countries
Government policies and trade barriers: Government policies and trade restrictions (taxes, tariffs, quotas) make trade expensive and affect prices differently in different countries
Non-Tradable Goods: Transaction costs make trade expensive, and in some cases make some goods non-traceable. Services are generally not tradable.

Question 20

What is the Balassa and Samuelson Effect:

Answer 20

Prices of non-tradable goods and services (haircutting, teaching,…) in developed countries are higher than in developing countries
Price Index, P, for developing countries tend to be lower
PPP predicts undervalued exchange rate for developing countries
PPP exchange rate is larger than nominal exchange rate (it is stronger then it looks)