Chapter 3
What does the assumption: when exchange rates may change, domestic-currency goods prices are fixed in the short run, allow?
fluctuation in the exchange rate cause fluctuations in the common-currency prices of goods from different countries; prices are sticky in the short run
M1
includes highly liquid instruments such as demand deposit in checking accounts and travelers checks
absolute PPP in terms of real exchange rates
purchasing power parity states that the real exchange rate is equal to 1
Law of ONe prices
-relates exchange rates to individuals goods -in an efficient market all identical goods must have only one price
Purchasing Power Parity Theory (absolute/relative) suggest
suggest that price levels in different countries and exchange rates are tightly linked
M0
the narrowest definition of money (base money)
Inflation
the rate of change of the price level
The relative price ratio is called
the real exchange rate (RER) (Q€/$)
What is the exchange rate used for
to convert the prices of goods and assets into a common currency to allow meaningful price comparisons
central bank can indirectly control the level of MI by using
monetary policy to influence the behavior of the private banks that are responsible for checking deposits
model that links prices to monetary conditions
quantity theory
Model in which the demand for money is proportional to dollar income
quantity theory of money
The rate of change of the price level is known as the
rate of inflation; simply inflation
RER^
real depreciation -more domestic goods needed to buy foreign goods -domestic goods cheaper compared to foreign goods -exports increase, imports decrease
Purchasing Power Parity implies
that the exchange rate at which two currencies trade is equal to the relative price levels of the two currencies
If both covered interest parity and uncovered interest parity hold,
the forward rate must equal the expected future spot rate
In practice, a country's central bank controls
the money supply, in this case by issuing notes and coins, the central bank controls directly only the level of MO
the demand for nominal money balances Md is proportional to
the nominal income, PY
RER
the price of domestic goods relative to foreign goods -says how much foreign goods you could get for domestic goods
Relative PPP implies
the rate of depreciation of the nominal exchange rate equals the inflation differential (the diference btw. the inflation rate of two countries) a. relative PPP predicts a relationship btw. changes in prices and changes in exchange rates, rather than a relationship btw. their levels.
If absolute PPP holds
then relative PPP must also hold
RER decrease arrow
-less domestic goods needed to buy foreign goods -domestic goods become more expensive compared to foreign goods -exports decrease, imports increase
All else equal, when the prices of goods are constant in domestic currencies, the following applies
1. Changes in the Erate cause changes in prices of foreign goods expressed in the home currency 2. Changes in the exchange rate cause changes in the relative prices of goods produces in diff. countries 3. when the home country's exchange rate depreciates against the foreign country, home exports become less expensive and visa versa
Real Exchange Rate
1. Is a real concept; says how many US baskets trade for one european basket (relative price of basket)
What explains deviation from PPP
1. Transaction Costs 2. Nonetraded goods 3. Imperfect conditions and legal obsticles 4. Price stickiness
Money performs 3 key functions in the economy
1. store of value: money holds from today until tomorrow and its rate of return is low compared with many other assets. We earn no interest on money 2. unit of account 3. medium of exchange -liquid
Spot exchange rate is determined by
1. the expected future exchange rate 2. the home interest rate 3. foreign interest rate
model that links exchange rates to prices
PPP
aggregate money demand :
all else equal, a rise in national dollar income (nominal income) will cause a proportional increase in transactions and hence, in aggregate money demand.
half of any PPP deviation still remains after four years:
an economist would refer to this as a four year half-life.
Goods that can be differentiated create conditions of .......
imperfect condition because firms have some power to set the price of their good. >Known as Market Power
Monetary Theory supplies
in the LR, price levels are determined in each country by the relative demand and supply of money
M2
includes less liquid assets such as savings and small time deposits
If the amount of money in circulation (nominal money supply) rises, and real income stays the same, then there will be
inflation "more money chasing the same quantity of goods"
Nominal Exchange Rate
is a nominal concept: says how many dollars traded for one euro E$/€
money
is the most liquid asset of all
The exchange rate in a country
is the price of a unit of foreign currency expressed in terms of the domestic currency. This price is determined in the spot market for foreign exchange.
Money
is the stock of liquid assets that are routinely used to finance transactions usually M1 (currency plus demand deposits_
Monetary approach to exchange rate
a theory that combines the monetary theory of price levels with the purchasing power (long run theory)
PPP applied to the future means
if we can forecast future price levels, then we can forecast the expected future exchange rate
RER can also affect external.....
competitiveness appreciation RER: decreases competitiveness depreciation RER: increases competitiveness
Relative PPP is an approximate
guide to the relationship between price and exchange rates in the long run
absolute PPP
holds when price levels in two countries are equal when expressed in a common currency