Lesson 6

Question 1

What is the difference between absolute PPP and relative PPP?

Answer 1

Absolute PPP → [q = E∙P*/P = 1.0]

Relative PPP → [q = E∙P* /P = k], where k > 0

Question 2

What happens to the equation in the LR?

Answer 2

In the long run there is no change in real exchange rate so there needs to be a proportional change for any changes in P, P*, or k

Question 3

What is LR Interest Parity?

Answer 3

R = R* + (πe – π*e)

Question 4

What happens when there is a 3% increase in the growth of the money supply?

Answer 4

A) Equal change in the inflation, and a one-time jump in the price level
B) Increase or decrease of the interest rate, equal amount
C) Equal change in the exchange rate, and a one-time jump in the rate

Question 5

Arguments against the assumptions of Absolute PPP

Answer 5

• International Trade is NOT Frictionless
  o Transportation costs, tariff’s and duties can all separate a domestic from a foreign market (can be up to 20% for transportation and another 10% for tariffs/duties)
• Some things ARE non-tradable
  o Services are very hard (impossible) to trade
  o Non-service goods still have service related costs (middle men, distribution costs)
• Many goods are differentiated
  o Often with trademarks and legal protection
  o This causes market power, which allows them to price to the market

Question 6

What does the General Model of Long Run Exchange Rates

Answer 6

CA (Y-A) on the X axis
Quantity on the Y axis
CA is a upward sloping curve
Vertical Line showing (Y-A)