PPP, Price Levels And Exchange Rates In The LR

Question 1

What is the real exchange rate?

Answer 1

• rate of exchange for goods and services across countries

Question 2

What is the formula for the real exchange rate

Answer 2

q=E X P(F) / P(H)

Hence,

E=P(H)/P(F) X q

Question 3

What does a real depreciation in the home currency mean?

Answer 3

• q increases
• implies value of domestic goods relative to value of foreign goods falls

Question 4

What does a real appreciation in the home currency mean?

Answer 4

• q decreases
• implies value of domestic goods relative to foreign goods rises

Question 5

Describe why relative demand is upward sloping

Answer 5

• as q increases foreign goods become more expensive
• demand for domestic goods increases relative to foreign goods
• domestic output increased

Question 6

When is real exchange rate at its equilibrium level?

Answer 6

When relative demand=relative supply

Question 7

Describe the effect of an increase in RD of domestic goods on the real exchange rate

Answer 7

• increase in RD of domestic goods shifts RD curve right
• value of formative goods relative to foreign goods rises
• excess demand
• real appreciation of domestic goods
• q falls
• real appreciation decreases exports
• increased imports
• NX falls
• reducing relative quantity demanded of domestic goods

Question 8

Describe the increase in relative supply of domestic goods

Answer 8

• RS curve shifts right
• domestic output has risen relative to foreign output
• causes price of domestic goods relative to cost of foreign goods to fall
• excess supply
• real depreciation of value of domestic goods
• q rosed
• imports fall
• exports rise
• NX rises
• increase im relative demand of US goods until equilibrium reached

Question 9

Describe an increase of relative demand of domestic goods on the nominal exchange rate

Answer 9

• increase in RD
• real exchange rate falls
• nominal exchange rate falls
• home currency appreciates
• nominal and real appreciation of domestic currency
• no effect on long-run price levels

Question 10

Describe the effect of an increase in relative supply of domestic goods on the nominal exchange rate

Answer 10

• increase in RS
• q rises
• increase in real output domestically increases real money demand
• domestic prices fall
• effect on nominal exchange rate is ambiguous

Question 11

What is the real interest parity?

Answer 11

The real interest rate differential = growth in the real exchange rate