Week 9 Determinants of Exchange rate Flashcards
What is LOOP?
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).
Why does LOOP need to hold?
-If not it arises for infinite arbitrage opportunities
-So prices will adjust to prevent this
For what goods does LOOP
HOLD
NOT HOLD
HOLD:
Luxury goods,
Oil,
Wheat
DOES NOT HOLD:
Big Mac
Haircuts
Restuarant meals
What are the reasons that LOOP might fail?
- May have non-traded input
-Barriers to trade
-Barriers to market
-price to market (market has different charactersitics).
What is purchasing power parity?
The same as LOOP but for a basket of goods
What is the real exchange rate?
It adjusts the nominal exchange rate for different prices between countries
Ratio of value of foreign basket in domestic currency compared to domestic basket
What is the equation for the real exchange rate?
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).
What are the different scenarios of the value of the RER
RER = 1 PPP holds
RER > 1 (Home basket is undervalued), (Foreign basket is overvalued)
RER < 1 (Home basket is overvalued) (Foreign basket is undervalued).
What does the differential of the RER tell you
diff e < 1 the RER depreciates in terms of domestic currency
diff e > 1 the RER appreciates in terms of domestic currency.
What is the difference between absolute PPP and relative PPP
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
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?
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
Does relative PPP hold in short run?
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
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?
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.
if you were comparing US and India with standard of living how would you do it?
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.
What is the Balassa-Samuelson effect?
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).
