Week 9 Determinants of Exchange rate Flashcards

1
Q

What is LOOP?

A

Law of one Price

States that a good should be the same price abroad and at home.

Pi = P*I S

Pi = domestic currency price good i
P*i = foreign currency price good i
S = exchange rate (for one unit of foreign currency).

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2
Q

Why does LOOP need to hold?

A

-If not it arises for infinite arbitrage opportunities
-So prices will adjust to prevent this

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3
Q

For what goods does LOOP
HOLD
NOT HOLD

A

HOLD:
Luxury goods,
Oil,
Wheat

DOES NOT HOLD:
Big Mac
Haircuts
Restuarant meals

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4
Q

What are the reasons that LOOP might fail?

A
  • May have non-traded input
    -Barriers to trade
    -Barriers to market
    -price to market (market has different charactersitics).
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5
Q

What is purchasing power parity?

A

The same as LOOP but for a basket of goods

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6
Q

What is the real exchange rate?

A

It adjusts the nominal exchange rate for different prices between countries

Ratio of value of foreign basket in domestic currency compared to domestic basket

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7
Q

What is the equation for the real exchange rate?

A

e = SP* / P

P = domestic currency price of basket of goods
P* foreign currency price of basket of goods
S = nominal exchange rate
e = (REAL EXCHANGE RATE).

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8
Q

What are the different scenarios of the value of the RER

A

RER = 1 PPP holds
RER > 1 (Home basket is undervalued), (Foreign basket is overvalued)

RER < 1 (Home basket is overvalued) (Foreign basket is undervalued).

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9
Q

What does the differential of the RER tell you

A

diff e < 1 the RER depreciates in terms of domestic currency

diff e > 1 the RER appreciates in terms of domestic currency.

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10
Q

What is the difference between absolute PPP and relative PPP

A

Absolute PPP is when e = 1
Domestic value of good is the same as foreign value of good in domestic currency

Relative PPP is when diff e = 0
Values will be different but they move in the same way over time

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11
Q

What test can you do to compare relative PPP to see if it holds.

What does the test show about relative PPP

What is a second method to compare relative PPP .Did this hold?

A

Take logs of real exchange rate and then plot the explanatory variables together.

Relative PPP holds in long run but not in short run

The real exchange rate differential must be equal to zero

The difference between US inflation and UK inflation should be = to the rate of depreciation of the foreign currency compared to the dollar.

It did hold backing up the relative PPP holds in long run

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12
Q

Does relative PPP hold in short run?

A

No,

does not hold in short run in fact is very volatile.
Prices and exchange rates do not adjust for these disturbances in the short run

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13
Q

Give an example of a good where absolute PPP may not hold:

Why may this be?

What is another example of the absolute PPP may not hold?

A

Big mac was computed and data showed that real exchange rate was not equalled to 1

This could be because it is non tradebale as you cannot trade a big mac

ICP report measures price indexes for baskets of goods and shows countries like Ethopia are much cheaper.

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14
Q

if you were comparing US and India with standard of living how would you do it?

A

You would use GDP at PPP as it takes into account the price levels of the respective economy as even though income is 32 times higher in US than India when taking into account buying power it is only 11 times bigger.

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15
Q

What is the Balassa-Samuelson effect?

A

Is the tendency for countries with higher productivity growth in tradeables compared to non-tradeables to have higher prices. (and hence appreciated real exchange rates).

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16
Q

What is the set up for the Balassa-Samuelson model?

A

2 goods: QT and QN
QT = Traded output = cars
QN = Non-Traded output = haircuts

Production QT = aT . LT
QN = aN . LN

aN/T = efficiency parameter in respective markets
L T / N is labour in market
W = Wage which is the same in both markets due to mobility.

Problem of firm (Traded good sector).
Profits = PT . QT - WLT

Subject to QT = aT . LT

Sub in QT

PT . AT = Wage

Do this again for non-traded sector

PT . AT = PN . AN

PN/ PT = aT/aN

17
Q

What does the Balassa Samuelson model show in equilibirium?

Does this hold in the data?

A

Predicts that in equilibrium:

Relative price of non-tradeables in terms of tradeables = relative productivty of tradeables to non-tradanles

PN / PT = aT/ aN

(inverse relationship)

There is a positive relationship as the Balassa predicts but is not on the 45* line
(other factors other than relative price that contribute to productivity growth).

18
Q

How else does the Balassa-Samuelson effect work?

A

Not only for domestic economy but also for foreign.

19
Q

What does the Balassa-Samuelson productivity model predict?

A

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

sub in productivity for prices

e = e = phi (1, AT/AN) / phi (1,AT/AN)

Therefore if in the foreign