Lesson 5

Question 1

When does Absolute PPP exist?

Answer 1

When at the current exchange rate between two currencies, each currency can purchase the same quantity of goods and services abroad as at home.

LR Real Exchange rate = 1

Question 2

What is the law of one price?

Answer 2

In a unified, competitive market unit of the same good must sell for the same price; any price differences at a given time will be eliminated through arbitrage (“buying low to sell high”.)

Question 3

What are the main assumptions we need to make for Law of One Price?

Answer 3

1. good i is tradable ‒ it can be exported or imported by either country;
2. there is zero cost of transporting good i between Europe and the U.S.;
3. there are no barriers to trade in good i (no tariffs, quotas, or other regulations which impede trade);
4. European and U.S. markets for good i are equally competitive.

Question 4

What is the equation for nominal exchange rate?

Answer 4

E$/€ = PUS/PE

Question 5

What are the assumptions for the adjustments?

Answer 5

1. Output prices are fixed in the short run and thereafter adjust gradually in response to excess demand or excess supply of goods and services.
2. In the short run both the domestic interest rate (R) and the exchange rate (E) instantly adjust to ensure continuous equilibrium in the domestic money market and foreign exchange market, respectively.
3. A permanent monetary change causes the expected exchange rate (Ee) to adjust immediately to equal the exchange rate consistent with the new long-run equilibrium in which absolute PPP prevails.
4. The level of aggregate output or national income (Y) does not adjust, even in the short run, to changes in aggregate demand for output.

Question 6

What does an increase in the Ms cause?

Answer 6

In the short run an increase in the money supply causes a rise in the exchange rate (a depreciation of the domestic)

Question 7

Why does short-run exchange rate overshooting occur?

Answer 7

The answer lies in the assumptions we made about the short run. First, we assumed that prices are fixed in the short run. As a result, an increase in the U.S. nominal money supply causes a short-run increase in the U.S. real money supply which leads to a short-run decrease in the U.S. interest rate. As the U.S. interest rate falls below the European interest rate, the dollar/euro exchange rate must rise to a level above the expected future value of the exchange rate to maintain interest parity:

If R$ < R€, then R$ = [R€ + (Ee$/€ ‒ E$/€)/ E$/€] only if, E$/€> Ee$/€.

But, secondly, we assumed that a permanent increase in the U.S. money supply will immediately cause the expected exchange rate to increase to match the new long-run equilibrium value of the exchange rate as predicted by our model (Ee2$/€ = E3$/€). Thus, to maintain interest parity the exchange rate must overshoot in the short run by increasing to a level above its new long-run equilibrium level (E2$/€ > E3$/€).