TERM 1: RER

Question 1

LOOP STATES

Answer 1

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

Question 2

LOOP formula for a given good i

Answer 2

Pi = Pi*S

Question 3

The nominal ER measures

Answer 3

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

Question 4

LOOP holds for (4)

Answer 4

Gold, oil, wheat, luxury consumer goods

Question 5

LOOP fails for (5)

Answer 5

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

Question 6

4 reasons why LOOP fails

Answer 6

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

Question 7

PPP measures

Answer 7

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

Question 8

RER formula

Answer 8

RER = e = SP* / P

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

Question 9

If e=1

Answer 9

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

Question 10

If e>1

Answer 10

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

Question 11

If e<1

Answer 11

SP*<p></p>

Question 12

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

Answer 12

NO because the domestic and foreign baskets could:

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

Question 13

Difference between absolute and relative PPP formulas

Answer 13

Absolute PPP: e=1 - prices same

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

Question 14

What does relative PPP mean for the RER?

Answer 14

change in e=0

Therefore RER is constant over time

Question 15

Logs to show relative PPP

Answer 15

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

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

Question 16

Does relative PPP hold?

Answer 16

YES - in the long run

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

Question 17

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

Answer 17

e decreases = RER appreciation for the domestic currency

Question 18

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

Answer 18

e increases = RER depreciation for domestic currency.

Question 19

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

Answer 19

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.

Question 20

IF St falls this means:

Answer 20

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

Question 21

IF St rises this means:

Answer 21

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

Question 22

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

Answer 22

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.

Question 23

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

Answer 23

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

Question 24

What does absolute PPP mean?

Answer 24

e=1, StPt* = Pt

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

Question 25

What data do we need to test absolute PPP?

Answer 25

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

Question 26

The big mac index tells us

Answer 26

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

Question 27

eBIGMAC for richer countries than US

Answer 27

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

Question 28

eBIGMAC for poorer countries than US

Answer 28

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

Question 29

Does absolute PPP hold according to big mac index?

Answer 29

NO - e ≠ 1

Question 30

What does it mean if St < St PPP

Answer 30

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 $..

Question 31

What does it mean if St > St PPP

Answer 31

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 $.

Question 32

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

Answer 32

The International Comparison Programm (ICP) | Established 1960s on recommendation of United Nations Statistical Commission (UNSC)

Question 33

What is the price level index

Answer 33

e = PLI = SP*/P | Where P* and P are actual price levels and not indices.

Question 34

Does absolute PPP hold for a basket of goods?

Answer 34

NO it FAILS as ex100 ≠ 100

Question 35

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

Answer 35

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.

Question 36

Why is PPP useful for standard of living comparisons?

Answer 36

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

Question 37

Why does absolute PPP fails?

Answer 37

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

Question 38

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

Answer 38

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

Question 39

2 assumptions we make

Answer 39

1. LOOP holds only for traded goods | 2. Price functions are homogeneous of degree 1

Question 40

RER using price functions and our 2 assumptions

Answer 40

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

Question 41

So, absolute PPP holds if:

Answer 41

PN*/PT* = PN/PT

Question 42

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

Answer 42

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.

Question 43

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

Answer 43

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

Question 44

The Balassa-Samuelson effect =

Answer 44

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

Question 45

Production fucntions x2 in Balassa Samuelson model

Answer 45

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

Question 46

Profit max condition in traded sector

Answer 46

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

Question 47

Profit max condition in non-traded sector

Answer 47

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

Question 48

EQUILIBRIUM in Balassa-Samuelson Model

Answer 48

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

Question 49

Take logs and growth rates for equilibrium condition in BS Model

Answer 49

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

Question 50

Does the BS Model equilibrium condition hold in the data?

Answer 50

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.

Question 51

RER using BS model equilibrium condition

Answer 51

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

Question 52

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

Answer 52

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

Question 53

One time the BS model explained RER changes well

Answer 53

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.

Question 54

One time the BS model explained RER changes not well

Answer 54

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

Question 55

Therefore, the BS model is...

Answer 55

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.