L12 Exchange Rates In The Classical Model Flashcards
Why would we have real appreciation?
- Home goods becoming more expensive - think about perceptions of both domestic and foreign consumers and the relative effects on M and X respectively
- Foreign goods become cheaper (in real terms)
1 dominates BUT CHALLENGE THIS ASSUMPTION
Want to decompose NX into its components. How do you then derive the Marshall-Lerner condition? (7)
NX = X - 1/ę • M
dNX/dę < 0
DEF : Marshall Lerner condition
A real appreciation worsens net exports if the sum of elasticity of imports and exports is greater than 1
Why is NX(ę) downward sloping?
Only because we’re assuming the M-L condition to hold
What does the ‘price-sensitive’ component of AD, NX(ę), replace in the closed-economy analysis?
Replaces I(r)
S-I(r*) = NX(ę)
ę adjusts to ensure aggregate expenditure equals Ŷ.
There are two diagrams we can get NX(ę) from.
- Savings and investment, given world interest rate r* (8)
2. The ę against NX schedule, where S-I is vertical
What kind of prices should matter in a classical economy?
Real ones!
What happens when G rises?
Increases domestic borrowing requirements
Puts pressure on LF market, r
Lender attracted to invest, capital inflows ensuring r=r* still holds
Inflows cause nominal e to rise, so ę rises until equilibrium is restored
NX, not I, is being crowded out here!
DEF: Law of one price and the PPP Hypothesis
What can it be view us re the NX(ę) schedule?
Consider: homogeneous tradable good with negligible transport costs relative to its value
Should be no difference between p at home in home currency and p in foreign country in foreign currency, corrected by nominal e
Ie ę=1, or p= p*/e
Arbitrage- profitable opportunity with price differences
ENTIRE basket of goods - PPP!
Can be viewed as a restriction
If PPP holds perfectly what would the NX schedule look like?
Well the exchange rate is fixed
Infinite elasticity demand for products, PPP should tend towards in medium term
Why does ę=1 seem unrealistic?
a) some goods can’t be traded eg services like haircuts
b) trade costs, tariffs, taxes -> scope for arbitrage limited
So SERVICES AND SCOPE
Tendency for countries to have more appreciated ę
Fits w belief cost of living lower in developing countries, why? What’s the effect called?
How do we model this?
There are productivity differentials between traded and non-traded sectors
BALASSA-SAMUELSON EFFECT
Proportion tradables and non-tradables, looking at aggregate P
-> richer countries will have higher RELATIVE price for non-tradables dude to p_t being smaller from tech advances
p_nt / p_t
DEF (exact) : Balassa-Samuelson effect
Real ę will be higher the higher is the relative price of home non-tradables vs tradables, compared to foreign
More efficiency in man-> higher Wr -> cross over to services w/o more E -> higher relative costs of non-tradables
