Ch 13. Econ 352
What is the best way for a country to eliminate currency overvaluation by raising the fundamental value of its nominal exchange rate until it equals the fixed value?
Contraction of its money supply.
If a fixed exchange rate system wanted to fight recession using money supply what are its avenues?
Create an overvaluation problem or devalue its currency immediately.
What is the flexible-exchange-rate system or otherwise known as the floating-exchange-rate system?
Exchange rates are not officially fiexed but are determined by conditions of supply and demadn in teh foreign exchange market
What is the relationship between real exchange rate and nominal exchange rate?
For given levels of domestic and foreign prices, that real exchange rate and the nominal exchange rate are proportional. If price levels are constant, all conclusions about the nominal exchange rate apply equally to the real exchange rate
What is an important thing to note about real interest rate?
Has no direct eeffect on net exports but it does have an indirect effect through the exchange rate. Increase in r raises the exchange rate so that domestic exports becomes more expensive and imports form abroad become cheaper
What is purchasing power parity (ppp) ?
Idea that similar foreign and dmoestic goods should have teh same price in terms of the same currency
What is an inconvertible currency?
A currency that can't be freely traded for other curencies.
What is real depcreation?
A drop in the real exchange rate, which decreases teh quantity of foreign goods that can be purchased with teh same quantity of dmoestic goods
How does the government act as a demander or supplier to fix its exchange rate? What is the problem with it?
An entity (usually the central bank) uses offical reserve assets to buy back its own currency.
What are 2 factors that contribute to strengthening a currency (a nominal appreciation)?
An increase in the relative price of countries exports ( a real appreciation) which might offur if foreign demand for tehse exports rises; a rate of domestic inflation, π, lower than that of the countries trading partner π(for)
Why is is that net exports do not increase though the exchange rate falls?
Because firms could lose many of their foreign customers, and that it could perminately incerease penetration of the U.S market by foreign producers, while similarilry reducing hte cabability of american firms to sell in foreign markets
With the flexible exchange rate, what is the relationship between the exhcange rate and net exports?
Because the U.S real exchange rate is the relative price of U.S goods, the real value of the dollar and U.S net exports should move in opposite directions.
For the J-Curve, what happens in the long run?
Because your goods are cheaper, the lower real exchange rate leads to larger export quantities and smaller import quantities, net exports begin to rise.
What is a speculative run?
Occurs when financial investors begin to fear that an overvalued currency may soon be devalued, reducing hte value of assets denominated in that currency relative to assets domnoinated in other currenies.
What is the equation for the price of domestic goods?
P = P(for)/e(nom)
What is the ppp evidence for the short and long run?
PPP holds out in the long run but not hte short run. This is because countries produce very diff baskets of goods (not the same as assumed for PPP); some times of goods and monst stervices are not interionallaly traded, and transportation costs and legal barriers may try to prevent the prices of traded goods and services from being equalitzed in dfferent countries
What is the real exchange rate?
Price of domestic goods relative to foreign goods - equivalently, the number of foreign goods someone gets in exchange for one domestic good
In defining real exchange rate what do we assume?
That each country produces a single, unique good
What does the ppp equation say and what is it?
That nominal exhcange rate should equal the foreign pirce level divided by the dmoestic price level e(nom) = P(For)/P
What happens if the dollar's nominal exchange rate rises?
The dollar has a nominal appreciation. The dollar has become stronger
What is nominal depreciation?
When nominal exchange falls so that a dollar buys fewer units of foreign currency. It is the same as saying the dollar has become weaker
What is the general conclusion about net exports?
the higher the real exchange rate is the lower a country's net exports will be
What is the foreign exchange market?
the market for international currencies
For the J-Curve, what happens in the short run?
when real exchange rate depreciates, in the short run. Net exports become more negative as the decline in the real exchange rate raises the real cost of imports.
What is the fixed-exchange-rate system?
where exhcnage rates were set at officially determined levels, often operated
How do restricting international transactions help set official exchange rates?
you can limit or tax imports or finaical outflows. They reduce the supply of th domestic ucrrency to the foreign exchange market, thus raising the value of the exchange rate toward the desired fixed value. some countries eve require government approval for all domestic and foriegn tranactions to control them
When a domestic car costs twice as much as a comparable foreign car, people will be more interested in buying foreign cars. This will cause more cars to be sold abroad and many cars important. The domestic economy's net exports will be what?
zero or negative
Because the term ΔP/P is the samea s the domestic rate of inflation (as well as the same logic holds for the P(for)), what does the Δe(nom)/e(nom) equal?
Δe(nom)/e(nom) = Δe/e + π(for) - π
What is the equation when real exchange rate is constant. What is this called?
Δe(nom)/e(nom) = π(for) - π ; The rate of appreciation of f the nominal exchange rate equals the foreign inflation rate minus the domestic inflation rate. This is called the relative purchasing power parity.
What is the equation for the percenage change in the real exchange rate?
Δe/e = (Δe(nom)/e(nom)) + (ΔP/P) - (ΔP(for)/P(for))
How does the government act as a demander or supplier to fix undervalued exchange rates?
central bank must supply its own currency to the foreign exchange thereby accumulating foreign resrves. This is dangerous because a country cannot continue to lose reserves indefinitely.
Instead of depreciation, under the terminology of fixed exchange rates, what is the weakning of a currency called?
devaluation
What is the equation for nominal exchange rate?
eP(For)/P
Suppose real exchange rate so that a domestic automobile costs only half of foreign cars. What will the net exports be?
high because everyone is gonna want it
When domestic income rises, consumers will spend more on all goods and services (including imports), what will happen to domestic output, net exports, other factors held constat?
output/income rises, and net exports must fall
In the supply and demand curve, what happens when the dollar is more expensive?
people demand fewer dollars, so the demand curve slopes downard. The equilibrium value of the dollar at point E.
What is a currency union?
When a group of countries agree to share a common currency
U.S residents supply dollars to foreign exchange marekt, thereby acquiring foreign currencies for two reasons what are they?
1. To be able to buy foreign goods and services (U.S imports) 2. To be able to buy real and financial assets in foreign countries (U.S finnacial outflows)
hat are the two [primary aspects of th interdependce of world's economies?
1. internaitonal trade incrased steadliy and the second is the introudction of intergration of financial markets
Foreign individuals or firms demand ollars in the foreign exchange market for 2 reasons what are they?
1. to be able to buy U.S goods and services (U.S exports) 2. To be able to buy U.S rela and financial assets (U.S financial inflows)
Though the conclusion that higher real exchange rate depresses net exports relys on what important qualificaiton?
Depending on how quickly importers and exporters respond to changes in relative prices, the effects of a change in the real exchange rate on net eports may be weak int e short run and may even go in the wrong way
What happens when there is an increased domestic output on the exchange rate? Specifically lead it up to exchange rate effects
Domestic residents must supply more domestic currency to the foreign exchange market. An increased supply of domestic currency causes its value to fall and thus the exchange rate falls.
Can fixed-exchange-rate systems expand money supply?
In a fixed-exchange-rate system, individual countries typically are not free to expand their money supplies to try to raise output and employment. Instead they money suppy is government by the same condidtion that hte official and fundamental values of the exchange rate be the same
In both the short and long run a moneteary contraction increases the fundamental value of the nominal exchange rate, or hteh value of the nominal exchange rate determined by supply and demand in teh foreign exchange market. NOMINAL NOT REAL INTEREST RATE
In both the short and long run a moneteary contraction increases the fundamental value of the nominal exchange rate, or hteh value of the nominal exchange rate determined by supply and demand in teh foreign exchange market.
Factors that increase foreigners' demand for the U.S exports and assets will also increase the foriegn-exhcange0market demand for dollars. What will this do for the dollar exchange rate?
Increase it (demand drive)
What does a rise in domestic real interest rate do?
Increases the demand for and reduces the supply of domestic currency. Increasedd demand and decreased supply of domestic currency leads to exhcange rate appreciation.
What is the relationship between a higher domestic money supply and a fundamental vlaue.
It creates a lower fundamental value. See page 506 to memorize grpah
What is the exchange rate? What does it often refer to?
It is commonly the nominal exchange rate. This is the number of units of foreign currency that can be purchased with one unit of the domestic currency
What is a problem with the fixed exhcange rate?
It is the value of the exchange rate set by the government. Thus it may not be the exchange rate determined by the supply and demand for currency.
What are two reasons why people care about the exchange rate?
It represents the rate at which domestic goods and services can be traded for those produced abroad. A second reason is that the real exchange rate affects a country's next exports, or exports less imports.
If the demand for foreign goods and assets declines they supply fewer dollars to foreign exchange marekt what will happen to the value of the dollar?
It will rise (supply drive)
How does a monetary contraction cause the real exchange rate to appreciate in the short run (keynesian)?
Reducing domestic output and increasing the real interest rate. This is because short run domestic and foreign price levels are fixed in the keynesian model and it indicates that the short run appreciation of the real exchange rate also implies a short-run appreciation of the nominal exchange rate
What does S (supply) and D (Demand) mean for the supply and demand (nominal exchange rate)?
S: Indicates the number of dollars that people are willing to sell in the foreign exchange market at each value of the U.S nominal exchange rate D: Shows the number of dollars that people want to buy at each nominal exchange rate
See page 507 for Argentina and Brazil
See page 507 for Argentina and Brazil
What is the beachhead effect?
The idea that the strong dollar permanetly increased the penetration of the U.S market by foreign producers, while similarily reducing the cpaabiity of american firms to sell in foreign markets
What is the link between real exchange rate and net exports?
The real exchange rate (price of domestic goods relative to foreign goods) helps determine the demand for domestic goods both in home and foreign markets
The sharp increase in the real exhcange rate int he first half of the 1980s was accomapnied by a decline in the U.S net exports. The decline of hte dollar after 1984 stimulated U.S net exports, but with a delay that probably reflected the J-curve
The sharp increase in the real exhcange rate int he first half of the 1980s was accomapnied by a decline in the U.S net exports. The decline of hte dollar after 1984 stimulated U.S net exports, but with a delay that probably reflected the J-curve
What are forward exchange rates?
They are prices at which you can agree now to buy foreign currency at a specified date in the future
How can you caluclate the percentage change in the real exchange rate
Use the definition of e = e(nom) P / P(for)
In the long run is money neutral? What does this mean about a monetary contraction on the real exchange rate NOT NOMINAL INTEREST RTE, and price live?
Yes. So in the LONG RUN a monetary ocntraction has no effect on the real exchange rate, but it does cause the domestic price level to fall. the real exhcange rate is also unaffected.
In 1987, real value of hte dollar began shrinking but in teh past, exports still kept decreasing. Did it rise in this year?
Yes. it proved the j curve. Though it was still negative
How is the real exchange rate denoted?
[e(nominal) * (P)]/ P(for) = e(nom) e(nom) = the nominal exchange rate P(for) = price of foreign goods, measured in the foreign currency P = The price of domestic goods, measured in domestic currency
If you get rid of the assumption in the textbook and admit tha countries produce thousands of different goods, how do you determine real exchange rates?
base it on price indexies like the GDP deflator
When did the gold standard system go away?
collapsed during the economic and financial rises of the 1930s.
What is the underlying control of a fiexed-exchange rate system?
exchange rates are changed only by official government action.
What are 2 major benefits of fixed-exchange rate systems?
fixed rates make trading goods and assets among countries easier and less costly. 2. Fiex exchange rates may imporve monetary policy discipline in teh sense that countries with fixed exchange rates typically are less able to carry out highly expansionry monetary policies; the result may be lower inflation in the long run
What is the fundamental exchange rate and the official exchange rate?
fundamental exchange rate is the rate in equilibrium, official exchange rate is the rate set by the government
What happens when there is an increase in foreign output/income to the exchange rate?
leads consumers to increase their spending on all goods and services, including the exports of the domestic country. The incrase in foreign demand for U.S goods also increases the demand for dollar, raising its value. This is opposite to an increase in domestic output/income.
look at pg 488 for helpful chart
look at pg 488 for helpful chart
What happened to currency in the early 1970s?
major industrialized countries of the world switched from fixed to flexible exchange rates
What is an increase in the real exchange rate, e called?
real appreciation
What is the terms of trade?
refers to an increase in the real exchange rate. It is good for a country in the sense that its citizens are able to obtain more foreign goods.
Instead of appreciation, under the terminology of fixed exchange rates, what is the strenghtening of a currency called?
revaluation
What is a problem with fixed excahgne rates?
takes away countrie's ability to use monetary policy flexibily to dela with them.