Exchange Rates

Question 1

Direct Quote

Answer 1

Domestic currency per unit of foreign currency

Question 2

Indirect Quote

Answer 2

Foreign currency per unit of domestic currency

Question 3

Relative Exchange Rates

Answer 3

RER= P/(Pᶠ/E) = (E×P)/Pᶠ

Pᶠ is foreign prices
P is domestic prices
E is exchange rate

RER > 1 → foreign goods are cheap in real terms
RER < 1 → foreign goods are expensive in real terms

Increase in RER = appreciation
Decrease in RER = depreciation

Question 4

Law of One Price

Answer 4

Idea that tradeable goods should sell for the same price everywhere, once prices are denominated in a common currency

p=Pᶠ/E

Question 5

Absolute PPP Hypothesis

Answer 5

Law of one price holds for all goods

Question 6

Relative PPP

Answer 6

Requires growth in RER to equal 0

Relative PPP →
o Domestic currency appreciates if foreign inflation exceeds domestic inflation
o Domestic currency depreciates if domestic inflation exceeds foreign inflation

Question 7

Changes to Supply and Demand of Currency

Answer 7

• Domestic households/firms that want foreign goods/services/assets → demand for foreign currency → supply of domestic currency
• Foreign households/firms that want domestic goods/services/assets → demand for domestic currency → supply of foreign currency
• Increase in interest rate → increase demand for domestic currency and reduces supply of domestic currency → appreciation
• Decrease in interest rate → decrease demand for domestic currency and increases supply of domestic currency → depreciation

Question 8

Fixed Exchange Rates

Answer 8

• Exchange rate undervalued if pegged at less than fundamental → excess demand for currency → central bank sells reserves
• Exchange rate overvalued if pegged at more than fundamental → excess supply of currency → central bank buys reserves
• Central banks can run out of reserves → force peg to be removed
• Unsustainable pegs invite speculative attacks

Question 9

Policy Trilemma

Answer 9

Central bank can only choose 2 of the 3 goals simultaneously:
o Independent monetary policy (setting interest rates)
o Fixed exchange rate
o Free international capital flows (no capital controls)