Topic 4: Exchange Rates

Question 1

Nominal Exchange rate:

Answer 1

E = $* / $

Question 2

Real Exchange Rate

Answer 2

e_R= EP/P*

Question 3

Purchasing Power Parity

Answer 3

When the law of one price holds and e_R = 1.

Question 4

PPP Exchange Rate

Answer 4

The Nominal rate where e_R would be equal to one.

‘the fair / exchange rate would give equal purchasing power’

E_PPP= P*/Py

Question 5

What causes the law of one price to break down?

Answer 5

• Not all goods & services are traded
• Trade is costly
• Trade takes time to adjust to real exchange rate changes
• Factor prices vary between countries cause costs of production to vary
• The degree of competition between firms varies between countries

Question 6

Over time, why might prices tend towards the LOP price?

Answer 6

Traded goods directly compete with home products, large price variations would be unsustainable.

Non-traded goods and services – and costly to trade tradeables – are compared indirectly by workers & multinational corportations that make sdecisions about the location of production.