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EC201 - MACRO TERM 1 > TERM 1: RER > Flashcards

TERM 1: RER Flashcards

1
Q

LOOP STATES

A

the same good should cost the same abroad and at home.

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2
Q

LOOP formula for a given good i

A

Pi = Pi*S

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3
Q

The nominal ER measures

A

S = how much domestic currency is needed to buy 1 unit of foreign currency.

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4
Q

LOOP holds for (4)

A

Gold, oil, wheat, luxury consumer goods

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5
Q

LOOP fails for (5)

A

Big Mac; housing; transportation; haircuts; restaurant meals.

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6
Q

4 reasons why LOOP fails

A
  1. Good has non-traded inputs
  2. Gov policies / regulations e.g. taxes
  3. Barriers to trade e.g. tariffs/quotas
  4. Pricing to specific markets e.g. pharmaceuticals
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7
Q

PPP measures

A

the average cost of a basket of goods across one country w.r.t. another - a cost of living comparison.

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8
Q

RER formula

A

RER = e = SP* / P

Price of a foreign basket in domestic currency / price of domestic basket in domestic currency.

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9
Q

If e=1

A

absolute PPP holds: same cost of living abroad and at home.

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10
Q

If e>1

A

SP* > P
The home basket is undervalued/foreign overvalues.
Cost of living higher abroad compared to at home.

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11
Q

If e<1

A

SP*<p></p>

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12
Q

If LOOP holds for all goods, does e=1 have to hold? Why/why not?

A

NO because the domestic and foreign baskets could:

(1) Have different goods
(2) Have different weights for same goods

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13
Q

Difference between absolute and relative PPP formulas

A

Absolute PPP: e=1 - prices same

Relative PPP: change in e = 0 - prices move together over time, but not necessarily equal.

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14
Q

What does relative PPP mean for the RER?

A

change in e=0

Therefore RER is constant over time

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15
Q

Logs to show relative PPP

A

ln(et) = ln(StPt*) - ln(Pt)

ln(StPt*) should move in tandem with ln(Pt) over time.

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16
Q

Does relative PPP hold?

A

YES - in the long run

NO - in the short run it can be very volatile.

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17
Q

If e decreases, what does this mean for the domestic currency?

A

e decreases = RER appreciation for the domestic currency

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18
Q

If e increases, what does this mean for the domestic currency?

A

e increases = RER depreciation for domestic currency.

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19
Q

Test 2 of relative PPP using k period log differences formula. If relative PPP holds…

A

ln(et) - ln(et-k) = ln(Pt/Pt-k) - ln(Pt/Pt-k) + ln(St/St-k). If relative PPP holds:
ln(Pt/Pt-k) - ln(Pt/Pt-k) = -ln(St/St-k)
Difference between foreign and domestic inflation rates = nominal ER depreciation of foreign currency against domestic.

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20
Q

IF St falls this means:

A

Require fewer dollars to buy 1 unit of foreign currency = dollar appreciates, but foreign currency depreciates and e falls (if no change in prices.

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21
Q

IF St rises this means:

A

Require more dollars to buy 1 unit of foreign currency = dollar depreciates, foreign currency appreciates and e rises (if no change in prices)

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22
Q

What SHOULD happen to the nominal ER if foreign inflation > domestic inflation?

A

If foreign inflation>domestic. e rises: RER depreciation for the dollar, appreciation of foreign currency. To offset this, we need S to fall i.e. foreign currency to depreciate.

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23
Q

What SHOULD happen to the nominal ER if foreign inflation < domestic inflation?

A

If foreign inflation < domestic, e will fall = RER appreciation for dollar. To offset this, need dollar to decrease in value i.e. increase St.

24
Q

What does absolute PPP mean?

A

e=1, StPt* = Pt

One dollar can buy the same basket of goods at home and abroad - same cost of living.

25
Q

What data do we need to test absolute PPP?

A

actual price levels Pt and St, not growth rates or indexes.

26
Q

The big mac index tells us

A

eBIGMAC = how many US big macs required to buy 1 foreign big mac

27
Q

eBIGMAC for richer countries than US

A

e > 1 - cost of living is higher in foreign country, therefore need > 1 US big mac to buy 1 big mac there.

28
Q

eBIGMAC for poorer countries than US

A

e < 1 - cost of living is lower in foreign country, therefore need < 1 US big mac to buy 1 big mac there.

29
Q

Does absolute PPP hold according to big mac index?

A

NO - e ≠ 1

30
Q

What does it mean if St < St PPP

A

StPt* < Pt therefore e<1
This means dollar is overvalued and foreign currency is undervalued. Need St to rise so that foreign currency appreciates against $..

31
Q

What does it mean if St > St PPP

A

StPt* > Pt therefore e>1
This means dollar is undervalued and foreign currency is overvalued. Need St to fall to that foreign currency depreciates against $.

32
Q

Who provides data on actual price levels so we can test absolute PPP for a BASKET of goods?

A

The International Comparison Programm (ICP)

Established 1960s on recommendation of United Nations Statistical Commission (UNSC)

33
Q

What is the price level index

A

e = PLI = SP*/P

Where P* and P are actual price levels and not indices.

34
Q

Does absolute PPP hold for a basket of goods?

A

NO it FAILS as ex100 ≠ 100

35
Q

Why is it useful to compare size of economies using PPP?

A

Because exchange rates –> overstate size of rich countries, understate size of poor countries. PPP accounts for the fact that a given income can buy more in poorer countries due to lower costs of living.

36
Q

Why is PPP useful for standard of living comparisons?

A

Comparing per capita incomes overstates the difference in SOL between rich and poor. Rich countries are systematically more expensive than poor.

37
Q

Why does absolute PPP fails?

A

Many goods are NOT traded internationally therefore price discrepancies are NOT arbitraged away through trade.

38
Q

Cobb-douglas price index for traded and non-traded goods

A

P = (PT)^1-a (PN)^a

39
Q

2 assumptions we make

A
  1. LOOP holds only for traded goods

2. Price functions are homogeneous of degree 1

40
Q

RER using price functions and our 2 assumptions

A

e = [phi(1, PN/PT)] / [phi(1, PN/PT)]

41
Q

So, absolute PPP holds if:

A

PN/PT = PN/PT

42
Q

when is e>1 i.e. RER depreciates for dollar?

A

When PN/PT > PN/PT
i.e. when the relative price of non-tradables to tradables is higher in the foreign economy than domestic. This means e>1 and the dollar is undervalued.

43
Q

One reason why relative traded nontraded price could rise for foreign vs domestic.

A

Productivity growth in the traded sector relative to non-traded sector is faster for the foreign country than domestic.

44
Q

The Balassa-Samuelson effect =

A

the tendency for countries with higher productivity growth in tradables compared to non-tradables to have higher prices and thus an appreciates RER.

45
Q

Production fucntions x2 in Balassa Samuelson model

A

QT = aT LT
QN = aN LN
Labour is the only input. exogenous labour productivity parameter.

46
Q

Profit max condition in traded sector

A

PT aT = W
aT = W/PT
i.e. marginal gain from extra worker = marginal cost in terms of real wage.

47
Q

Profit max condition in non-traded sector

A

PN aN = W
aN = W/PN
i.e. marginal gain from extra worker = marginal cost in terms of real wage.

48
Q

EQUILIBRIUM in Balassa-Samuelson Model

A

PNaN = PTaT
PN/PT = aT/aN
relative price of non-traded to trade = relative productivities of labour

49
Q

Take logs and growth rates for equilibrium condition in BS Model

A

%Change(PN/PT) = %changeaT - %changeaN

50
Q

Does the BS Model equilibrium condition hold in the data?

A

Plot growth rate differentials of factor productivities against relative growth of prices for a country. Doesn’t quite follow45 degree line. But positively related using 15-year averages.

51
Q

RER using BS model equilibrium condition

A

e = [phi(1, aT/aN)] / [phi(1, aT/aN)]

52
Q

%changeRER formula using BS model equilibrium condition and Cobb-Douglas price functions.

A

%change e = alpha[%change(aT/aN) - %change(aT/aN)]

53
Q

One time the BS model explained RER changes well

A

German mark depreciated against Italian Lira 1970s/80s.

If e increased, this means %change(aT/aN) should be greater for Italy than Germany = supported by data.

54
Q

One time the BS model explained RER changes not well

A

Japanese Yen appreciated against US dollar. Not explained by differences in relative traded-nontraded productivities according to data.

55
Q

Therefore, the BS model is…

A

sometimes good as explaining LR changes in RER through differences in relative productivity growth rates, but other times there are alternative explanations not in model.

EC201 - MACRO TERM 1 (9 decks)

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