Exchange Rates I: The Monetary Approach in the Long Run Flashcards
All else equal, an increase in national dollar income (nominal income) will cause a proportional increasing in _________ and, hence, in ___________
transactions
aggregate money demand
All else equal, a rise in nominal interest rates will cause the _______________ to fall.
aggregate demand for money
Money demand is proportional to ________, and is a decreasing function of the _____________.
nominal income
nominal interest rate
What does the law of one price state?
The law of one price states that…
in the absence of trade frictions (such as transport costs and tariffs), and under conditions of free competition and price flexibility…
identical goods sold in different locations must sell for the same price when prices are expressed in a common currency.
PPP holds when price levels in two countries are…
equal when expressed in a common currency
If the real exchange rate rise, we say that Home has experienced a ______________.
real depreciation, because more Home baskets of goods are needed to buy one foreign basket of goods
If the real exchange rate falls, we say Home has experienced a _____________.
Real appreciation, because less Home baskets of goods are needed to buy one Foreign basket of goods.
The rate of growth of the price level is known as…
rate of inflation, or simply inflation
What is inflation?
Inflation refers to a rise in the price level due to money supply growth outpacing the economy’s growth.
Inflation may be caused by a shift of the demand curve up and to the right, or by an adverse supply shock.
Alternatively, if the cost of inputs rise, suppliers will pass on some of those costs on to consumers through higher prices. This is known as cost-push inflation.
What is deflation?
Why is this considered such a bad economic situation?
Deflation occurs when the prices of goods and services decline. This occurs when economic growth is faster than the growth of the money supply.
This is considered to be a bad thing because as prices fall, consumers will curtail spending due to the fact that their cash becomes more valuable as prices fall. This lack of spending is detrimental to developed economies who depend largely on consumption to drive demand for goods and services.
Additionally, deflation will have a negative effect on investments. Borrowers will not borrow unless the net present value of their investments are large enough to justify the risks. Since every dollar can buy more and more goods, nominal wages fall but loan payments remain fixed, meaning that investors must earn more income in order to keep up with loan payments.
The lack of demand for goods and services causes prices to fall further, leading to contracting margins for firms, which lead to massive layoffs and cost cuts.
What measure is typically the narrowest definition of money? What does this measure include?
M0 is the narrowest definition of money.
It is also called “base money”
It includes:
- currency in circulation
- reserves of commercial banks (liquid cash held in their vaults or on deposit at the Fed)
What does M1 include?
Includes:
- currency in circulation
- highly liquid instruments (such as demand deposits in checking accounts and traveler’s checks).
Excludes:
1. bank’s reserves
What does the Fisher effect tell us?
Nominal interest rate differential = Nominal inflation rate differential (expected)
This equation predicts that changes in the expected rate of inflation will be fully incorporated (one for one) into changes in nominal interest rates.
Explain uncovered interest parity.
Traders will be indifferent to a higher Home interest rate relative to Foreign’s home interest rates (making Home interest rates more attractive) only if the higher Home rate is offset by an expected depreciation in the Home currency (making Home deposits look less attractive).
The Fisher effect tells us that, in each country, the long-run expected nominal interest rate is the…
long run world interest rate plus that country’s expected long run inflation rate.
