Lecture Note #7

Question 1

Compare annual inflation rate of advanced countries and emerging and developing countries.

Answer 1

annual inflation is higher in emerging and developing countries compared to advanced countries

Question 2

Why does high inflation rate imply a drag on consumer and business spending?

Answer 2

its high volatility of relative prices create high uncertainty for economic decisions to be made

Question 3

In practice, why is it that every time prices go up, real wages can go either up or down?

Answer 3

the real wage is a relative price, formula: real wages = (nominal wages)/(price level)

if nominal wage rate is higher than inflation rate than real wages go up

if nominal wage rate is lower than inflation rate, than real wages go down

Question 4

What is the result of the law of One Price?

Answer 4

Local price = (Nominal Exchange Rate) x (International Price)

Question 5

What is the difference between tradable inflation and non-tradable inflation , considering theoretical and practical?

Answer 5

Tradable inflation is often influenced by external shocks (currency depreciation, etc.)

Non-tradable inflation depends more on domestic economic conditions and structural factors

Question 6

What is an important assumption about the Law of One Price?

Answer 6

there are no transportation costs and no tariffs or other impediments to trade

Question 7

Why are the two equations not identical ways of presenting the law of one price?

Local Price = NER x International price and

Δ%Local Price = Δ%NER + Δ%International Price

Answer 7

First equation is about price levels and the direct conversion

Second equation is about price changes and how movements in exchange rates and international prices affect local prices

Question 8

What are the two reasons for the price of non-tradables to go up?

Answer 8

1. demand-pull inflation
2. cost-push inflation

Question 9

What is the stagflation case?

Answer 9

shows how inflation doesn’t need demand’s cooperation, inflation could rise while aggregate demand and output fall

Question 10

What can be said about inflation expectations and actual inflation?

Answer 10

Most of the time, inflation expectations are a reliable predictor of actual inflation

Question 11

What does the empirical positive effect on wages on the overall inflation rate suggest about non-tradables?

Answer 11

non-tradable inflation matters in practice for overall inflation

wages rise -> non-tradable inflation increases -> overall inflation rises

Question 12

What does the empirical effect of the nominal exchange rate on the overall inflation rate suggest about tradables?

Answer 12

tradable inflation matters in practice for overall inflation

Question 13

How does high inflation influence people’s expectations?

Answer 13

People’s expectation of future inflation is based on current and past inflation

Question 14

Considering importers and exporters, what happens when economies move from autarky to full capital mobility?

Answer 14

capital importers and exporters have a net gain

Question 15

What are the five implicit assumptions of the basic capital mobility models?

Answer 15

1. fixed interest rate
2. exchange rates
3. cash flow certainty
4. responsible indebtedness
5. investor rationality

Question 16

Are capital inflows (foreign saving) important in financing national investment?

Answer 16

No, foreign saving is not a large part of financing national investment

Question 17

Based on the interest rate parity equation, what are the three necessary conditions for the local interest rate to be equal to the international rate?

Answer 17

1. the investment is safe (no default risk)
2. no exchange rate risk
3. same transaction costs

Question 18

What does a high sovereign spread usually mean?

Answer 18

sovereign spread classifies greater risks and volatility by bp so 200 bp is low, would describe advanced countries but 800 bp is common for emerging countries

Question 19

Considering interest rate parity, what does i and i* mean?

Answer 19

local interest rate (i) and international/foreign interest rate (i*)