PPP, Price Levels And Exchange Rates In The LR

Question 1

What does the Law of one Price state?

Answer 1

• price of the same good (using a common currency) in different competitive markets must be the same if transaction costs and barriers between markets are negligible

Question 2

What is PPP?

Answer 2

• application of LOOP across countries for all goods and services

Question 3

What does Absolute PPP suggest?

Answer 3

• general level of prices, converted to a common currency will be the same in every country
• exchange rates equal the ratio of relative average prices across countries

Question 4

What does the monetary approach to exchange rates predict?

Answer 4

• levels of average prices across counties adjust so that the quantity of real monetary assets supplied will equal the quantity of real monetary assets demanded

Question 5

According to Absolute PPP describe what happens when there is a permanent increase in the money supply?

Answer 5

• permanent increase in the Ms causes a proportional increase in the domestic price level in in order to keep real money supply constant
• results in a proportional depreciation of the domestic currency / increase in E to ensure PP across countries is unaffected

Question 6

According to Absolute PPP describe the effect of an increase in the domestic interest rate?

Answer 6

• increase in the interest rate means there is an increase in the opportunity cost of holding money
• demand for money falls
• prices rise to compensate
• proportional depreciation in the domestic currency required to maintain purchasing power

Question 7

According to Absolute PPP describe the impact of a rise in the output level

Answer 7

• rise in output level increases demand for money
• this is associated with a decrease in the average domestic price level
• causing a proportional appreciation of the home currency to ensure PP is unaffected

Question 8

What does Relative PPP say ?

Answer 8

• the rate of change in the exchange rate equals the inflation differential between two countries

Question 9

Combining the interest rate parity condition and Relative PPP what do we find?

Answer 9

• the nominal interest differential equals the expected inflation differential

Question 10

What is the fisher effect?

Answer 10

• a rise in the expected inflation rate in a country caused an equal rise in its nominal interest rate

Question 11

What came be said about the real interest rates across countries

Answer 11

According to Relative PPP real interest rates across countries should be equal

Question 12

Using the money market equilibrium condition, Relative PPP and the fisher effect describe the impact an increase in domestic Ms growth has

Answer 12

• according to the fisher effect the domestic nominal interest rate will increase because of the increase in inflation caused by the increase in Ms
• the increase in RH decreases the demand for money
• for the money market to maintain equilibrium in the LR prices must jump up
• From relative PPP, E must also jump up (domestic currency depreciates)

Question 13

Why do prices, interest rates and the exchange rate jump?

Answer 13

• we form expectations about the rate of inflation before the CB actions the policy

Question 14

What are the shortcomings of Absolute PPP?

Answer 14

• there is little empirical support

Question 15

What are the shortcomings of Relative PPP?

Answer 15

• more consistent with data
  May not be accurate because:
• trade barriers and non traceable products
• imperfect competition
• differences in measures of average prices for baskets of goods and services

Question 16

Describe the main differences between the Model of Inflation and Expectations and the Monetary approach ?

Answer 16

• in the model of inflation and expectations inflation is expected to zero in the LR but non-zero in its transition into LR equilibrium
• in the monetary approach the rate of inflation increases permanently when the growth rate of Ms increases permanently pressure
• in the model of inflation and expectations the level of average prices does not immediately adjust cashing the exchange rate to overshoot its LR value
• in the monetary approach the level of average prices adjusts with expectations of inflation causing domestic currency to depreciate but with no overshooting