Absolute Purchasing Power Parity and Real Exchange Rates

Real effective exchange rates - a trade weighted average of real exchange rates (real effective exchange rate) is tracked relative to a ______ _____ which is usually = _____ - real exchange rates are from the _____ trading partners perspective (aka R(____/____)) which changes equations slightly (give new equations)

base year, 100, foreign, F/$, R(F/$)= (exchange rate of F/$ x P of $)/P of foreign currency= 1/R($/F)

When we say that a currency appreciates we have to - state relative to what other _____ - express the exchange rate in appropriate terms Depreciation is just _____ appreciation

currency, negative

Spot exchange rate= the amount of numerator currency required to buy one unit of ______ currency

denominator

Big mac index: an index used to find _____ _____ through comparing sale price of big mac in countries around the world - exchange rate found in this index is.... (provide fraction) - must invert that fraction to find out if a foreign currency is _____ or ______ in comparison to the dollar - implied purchasing power parity=______ purchasing power parity in the index

exchange rates, foreign currency/$, undervalued, overvalued, absolute

Overvalued currencies have greater ______ purchasing power than _____ purchasing power - ______ is the financial driver of trade Undervalued currencies have greater ______ purchasing power than ______ purchasing power

external, internal, overvaluation, internal, external

The law of one price works super well in ______ _____ (stocks for ex) and ______ (gas for ex) but not for sale of ______ because this is regulated by consumer buying activity

financial investments, commodities, goods

When APPP holds, a firm might make its investment and exporting decisions without great concern for exchange rate ______ When APPP doesn't hold (which drives trade), must explore international trade decisions by using the _____ exchange rate - note: in a firm's exports/imports decision the proper bundle to evaluate in the ____ exchange rate is now the ______ good to be exported/imported

fluctuations, real, real, individual

______ purchasing power is the number of domestic consumption bundles purchasable with one unit of domestic US currency ______ purchasing power is the number of foreign consumption bundles (ex. Japan bundle) purchasable with one unit of domestic US currency - give final equation with Japan example

internal, external, yen per dollar x goods per y= goods per dollar in Japan

_____ ______ conditions link exchange rates and exchange rate changes to ____, _______, and _____ rates

international parity, prices, inflation, interest

Is foreign direct investment preferred in countries whose currency is over or undervalued? (answered below) traditionally... - overvalued F (R($/F) > 1): this indicates that foreign goods are more expensive for Americans. this makes it more expensive to ______ in the country so it is recommended to _____ in the US and _____ to foreign country

invest, invest, export

Is foreign direct investment preferred in countries whose currency is over or undervalued? (answered below) traditionally... - undervalued F (R($/F) < 1): this indicates that foreign goods are cheaper for Americans. this makes it cheaper to ______ in the foreign country so it is recommended to _______ in foreign country and _____ foreign goods to US (however when goods go to market the _____ wont be as substantial)

invest, invest, import, profits

Absolute purchasing power parity: rate that preserves ______ power which preserves _____ _____ - calculated by weighing average of all _____ _______ and ______ for one country and comparing it to that of the other country - price index is used to estimate _______ - absolute purchasing power states that exchange rates adjust such that _____ and _____ purchasing power are equal

purchasing, exchange rates, consumer goods, services, inflation, internal, external, exchange rate

What are the two detriments of exchange rates we have already learned about?

quantity theory of money, balance of payments

Economists are more interested in the ____ ______ exchange rate which is an average of the bilateral real exchange rates between a country and each of its trading partners, weighted by the share of trade with each partner - they are less interested in real exchange rate because it only considers _____ bilateral real exchange rate

real effective exchange rate, one

Why might APPP not hold? Inability to arbitrage/exploit and extinguish ______ differences - high _____ costs - non tradeable _____ and ______ (as well as housing location): these markets are very disconnected and the only way to unite is through _____ which takes 1/2 a century - non tradeable _____: for ex. perishables

price, transportation, services, labor, migration, goods

If the law of one price is imposed on an identical basket of goods in two countries, we have a condition known as _____ _____ ____ (in its various forms this constitutes one overall approach to ____ ____ determination) - this basket may or may not do a better job of capturing a _____ level than a single good - the value that exists with a comparison of perfect markets is called the _____ ____ ____ ____ (APPP) exchange rate - give equation (2) of them

purchasing power parity, exchange rate, price, absolute purchasing power parity, exchange rate of currency A/currency B)= Price of currency A/Price of currency B), vice versa on fraction for exchange rate of currency B/currency A

______ _____ describes the rate at which currency can be converted into real goods and services ______ ______ ______ is the equivalence in purchasing power of a currency at home and in a foreign country (after conversion)

purchasing power, purchasing power parity

Does real or nominal exchange rate drive trade? because this tells you the cost of ____ v profit of ______ - proven by balance of payments

real exchange rate. importing, exporting

The ____ ____ rate removes currency from the calculation and expresses the rate of exchange in real goods alone - usually calculated using consumption ______ except when looking at a particular good - notated as R, this end value is the ratio of relative ______

real exchange, bundles, consumption

Give appreciation equation Give depreciation equation Does one currency appreciate relative to another currency at the same percent that the other depreciates in response?

(appreciated value - original value)/original value, negative appreciation/(1 + appreciation), no

Formula for over and undervaluation (provide) - if positive then currency is ______ in comparison to the dollar - if negative then currency is _______ in comparison to the dollar

(exchange rate of $ over foreign currency - exchange rate of $ over FC APPP)/exchange rate of $ over FC APPP, overvalued, undervalued

APPP holds up well over the very _____ run but poorly for _____ time periods because... - the speed of convergence to APPP is too ____ (largely due to ______ _____ volatility) APPP works better during periods of _____ _____ because the adjustment of prices is more frequent

- long, shorter, slow, exchange rate, high inflation

If APPP holds, the real exchange rate is equal to ______ - if the foreign currency is overvalued (dollar is ______) relative to APPP the real exchange rate is ____ 1 (therefore _____ domestic goods must be exchanged per foreign good) - if the foreign currency is undervalued (dollar is _____) relative to APPP the real exchange rate is ____ 1 (therefore _____ domestic goods must be exchanged per foreign good)

1, undervalued, >, more, overvalued, <, less

Real effective exchange rate index equation is... - what does w represent - what does R represent - what does barR represent

Index= (w1 x (R1(F/$)/barR1(F/$)) +....) x 100, relative trade weight with certain country, US real exchange rate relative to certain country, US real exchange rate relative to certain country in base year

The firm must evaluate the cost of an import v the sale revenue of an export (cost of importing v sales in exporting) - give equation for both - the equation indicates how these costs and sales are associated to _____ exchange rate which can lead us to conclude that a _____ real exchange rate is a prerequisite to consider ______

P of $ x R($/F), real, favorable, exporting

The real exchange rate is defined in terms of the nominal exchange rate and the price levels of consumption bundles in the respective countries - give equation for $/F (and state how this changes when F/$)

R($/F)= (exchange rate of $/F x P of foreign currency)/P of $, R(F/$)= (exchange rate of F/$ x P of $)/P of foreign currency

International Parity Conditions under... - Relative Prices and Inflation Differences (name two) - Interest rate differences (name two) These form the core of the financial theory unique to ______ finance

absolute purchasing power parity and relative purchasing power parity, uncovered interest rate parity and covered interest rate parity, international

However, a driver of foreign direct investment exists in overvaluation circumstances - where foreign currency is overvalued and there is expected _____ in the future because when these FDIs go to market with product in foreign country their ____ will be higher than at home and these _____ are expected to increase even more following the foreign currency _____ - furthermore, another pro of investing in this situation is the lower ______ costs due to lower _____ costs of intermediate goods

appreciation, profits, profits, appreciation, production, import

Under conditions of free floating exchange rates with no capital controls, the parity conditions show exchange rates and exchange rate adjustments are determined in equilibrium by (three factors, name them) - parity conditions hold better here In fixed regimes the parity conditions provide a measure of misalignment relative to ______ forces and an indication of the _____ of the pegged rate

relative prices, inflation rate differences, interest rate differences, economic, sustainability

Why might APPP not hold? - ______ and _____ can distort prices for goods that are traded, creating a difference from the currency market _____ ____ - residents in different countries have different _____ for goods and consume _____ consumption baskets/bundles - different levels of ______ (monopoly v perfect competition)

tariffs, quotas, exchange rates, tastes, different, competitiveness

The real exchange rate is also simply the ratio of nominal exchange rate and the ____ exchange rate - write this down

APPP, R($/F)= exchange rate of ($/F)/APPP exchange rate of ($/F)

Review slide 79 question Discussion: The government just released international exchange rate statistics and reported that the trade-weighted real exchange rate index for the US dollar decreased from 105 last year to 95 currently and is expected to fall still further in the coming year. Other things equal, US ________ think this is good news and US ________ think this is bad news. A) importers; exporters B) importers; importers C) exporters; exporters D) exporters; importers

D

If one identical product or service can be sold in two different markets and no restrictions or costs exist on the sale or transportation of the product between markets, the product's price should be the same in both markets (define this principle) - if the markets use different currencies then this principle becomes... (give 2 ex equations) - violation of this principle is a driver of ______ - the primary principle of ______ ______ states that prices will equalize across markets if frictions (like described above) do not exist

law of one price, Price of currency A= exchange rate (A/B) x Price of currency B, Price of currency B= exchange rate (B/A) x Price of currency A, trade, competitive markets

Overvaluation tells us that foreign goods are x% _____ expensive for Americans Undervaluation tells us that foreign goods are x% _____ expensive for Americans

more, less

Alternatively, the real exchange rate R($/F) tells us the number of dollars needed in foreign currency (after conversion) to purchase the amount of consumption that _____ ____ can purchase in the US - proof for real exchange rate equation that focuses on nominal exchange rate and the price levels of consumption bundles in the respective countries (rewrite equation for R($/F)) - simply, the real exchange rate R($/F) is the ratio of the dollar price of goods ______ to the dollar price of goods at _____

one dollar, R($/F)= (exchange rate of $/F x P of foreign currency)/P of dollar, abroad, home

APPP and actual exchange rate relationships APPP > actual exchange rate then the foreign currency is ________ relative to base currency (dollar for example) or the base currency is _____ relative to the foreign currency APPP < actual exchange rate then the foreign currency is ______ relative to base currency or the base currency is ______ relative to the foreign currency

overvalued, undervalued, undervalued, overvalued

Is the big mac index a joke? - good index construction because the burger is prepared the same in all countries, price reflects the same ______/proportions on all components, and Mcdonalds uses local supplies for the components so the index reflects local _____ with little transportation costs - but there is inability to _______ (buying good at low price and selling it for high price- like done in financial indexes like stock exchange) price differences because a big mac is perishable

weights, prices, arbitrage,