Lecture 9: Exchange Rates

Question 1

Nomial (bilateral) exchange rate

Answer 1

Relative prices of one country in terms of another - units of foreign currency per domestic currency e.g. 0.75 USD per AUD

Question 2

Real exchange rates

Explanaition and formula

Answer 2

Relative price of one consumption basket in terms of another
RER = P/[P*/E] = EP/P^ (^=asterix)

when RER > 1 foreign goods seem cheap in real terms

Question 3

Growth in real exchange rate formula

Answer 3

g(RER) = g(E) + g(P) - g(P*)

Question 4

Exchange rate regimes

Answer 4

1. Floating - market determined relative price of currency through demand and supply for the currecny - the float can be dirtied which means intervention has occured
2. Fixed - policy makers set price of the currency which is wither currency standard (fixed to another country) or commodity standard (fixed in terms of something else e.g. gold)

Question 5

How are fixed exchange rates maintained?

Answer 5

By policy makers taking the other side of the economy - they must have reserves in order to absorb excess demand or supply depending on the economy - must buy/sell foreign currency

Question 6

Law of one price

LONG TERM

Answer 6

Tradeable goods should sell for the same price everywhere once denominated in a common currency (to a minor variation)

Question 7

Purchase power parity

LONG TERM

Answer 7

Hypothesis that the law of one price holds for the whole consumption basket ie. purchasing power is same in both countries - this suggests that RER = 1 in the long-term (from equtation of RER subbing in P=P*/E

Question 8

Long-run exchange rate growth formula

Answer 8

= g(P)-g(P*) - as RER=1

Question 9

Positives and negatives of PPP in practice

Answer 9

1. Provides a good guide to long-run exchnage rate dynamics and demonstrates when a counrty is experiencing high inflation
2. Poor guide to short-run exchange-rate dynamics, especially for countries with low and stable inflation

Question 10

Concerns with a fixed exchange rate

Answer 10

1. The rate could be fixed at a level that is too high or low relative to fundamentals - overvalued or undervalued
2. Gov expenditure in order to maintain the peg which draws on international reserves

Together if the rate is too hight maintaining this rate will eventually drain reserves, forcing devaluation

Question 11

Speculative attacks

Answer 11

The mass selling of domestic currency assets when investors expect a devaluation which brings forward this very devaluation

Question 12

Policy Trilemma

Answer 12

Can only choose two of the following goals:
1. Independent monetary policy - setting r as needed to address domestic conditions
2. Fixed exchange rate
3. Free international capital flows (no capital controls)

Question 13

Importance of exchange rates

Answer 13

Determines the relative value of a country’s imports and exports which influences capital flows through expected changes in exchange rates.