Econ 2035 Chapter 8 Notes

1. If inflation rises in a foreign country, domestic currency increases in value. Therefore foreign currency depreciates, and domestic currency appreciates. 2. In the long run, the real exchange rate = 1

2 Implications of the Theory of Purchasing Power Parity:

1. Not all goods and service are tradable 2. Products are not identical 3. Doesn't account for barriers to trade (like tariffs or quotas)

3 Drawbacks of the Theory of Purchasing Power Parity:

If Americans demand foreign goods they will have to go to the Market for Foreign Exchange and supply it with dollars in exchange for foreign currency. When the supply of dollars increases, the value of the dollar depreciates.

Suppose Americans demand more foreign goods. What happens to the value of the U.S. dollar?

When U.S. interest rates increase, more people will want to save their money in the U.S. (for the more profitable interest rate), so demand for the dollar increases. When demand for the dollar increases, the dollar appreciates.

Suppose U.S. interest rates increase relative to foreign interest rates. What happens to the value of the U.S. dollar?

depreciated; appreciated cheaper; more expensive

Suppose the exchange rate changes from $17 per peso to $20 per peso. The dollar has _______________ against the peso and the peso has _______________ against the dollar. This means American goods become ____________ in Mexico, and Mexican goods become _______________ in America

When demand for U.S. goods increase, the demand for the U.S. dollar will also increase. When demand for the U.S. dollar increase, the dollar appreciates.

Suppose the foreign demand for U.S. goods increases, what happens to the value of the U.S. dollar?

If the exchange rate (E) is low, then the cost to convert foreign currency to U.S. dollars is low, so the quantity demanded is high

What happens to quantity demanded when the exchange rate (E) is low?

If the exchange rate (E) is high, the U.S. will receive a lot of foreign currency for every dollar, so the quantity supplied is high

What happens to quantity supplied when the exchange rate (E) is high?

Foreigners demand U.S. dollars so they can buy American goods, services, and financial assets

When looking at the demand and supply model of short-tun fluctuations of exchange rates, who demands U.S. dollars?

Americans supply U.S. dollars to get foreign currency in return

When looking at the demand and supply model of short-tun fluctuations of exchange rates, who supplies U.S. dollars?

*E

is the nominal (market) exchange rate expressed as units of foreign currency per unit of domestic currency --In other words it is yen per dollar

Currency Premium

represents the expected appreciation of the domestic currency -can be used to compensate for Exchange Rate Risk

Law of One Price

states that identical good should sell for the same price -in other words, the real exchange rate should equal 1

Foreign Exchange Market

the financial market in which exchange rates are determined; an over the counter market where you can exchange one currency for another

(Nominal) Exchange Rate (E)

the price of one currency relative to another -expressed as units of foreign currency per units of domestic currency

Real Exchange Rate

the rate at which you can exchange goods and services in one country for goods and services in another country; it is adjusted for purchasing power

Exchange Rate Risk

the risk of exchange rates changing while holding a foreign asset --may require a currency premium, to compensate for the risk

Theory of Purchasing Power Parity

theory stating that (nominal) exchange rates move to equalize the purchasing power of different countries

Interest Rate Parity

when domestic interest rates = foreign interest rates - a currency premium - the expected appreciation of the domestic currency

Depreciation

when the value of one currency decreases relative to another

Appreciation

when the value of one currency increases relative to another