ECON

how to compute real exchange rate

Real Exchange rate = nominal exchange rate times Relative Price ratio ε = e (P$/P€)

factors shifting AD curve: Government purchases (G)

increase: Rightward decrease: Leftward

Law of One Price

A good in either country will have the same price after converting the currency. For example, the Price of a Big Mac in U.S. $ = Price of Big Mac in € once the currency in converted. P$(e) = P€ Where e is the nominal exchange rate, (€/$). The LHS of the equation converts the good in US$'s to Euro terms. The RHS of the equation is the price of the good in Euro terms. The Equation shows the good priced in US$ terms to be equal to the good priced in Euro terms after the US$ is converted to Euro.

The Effects of Capital Flight on an open economy on the graphs

If people decide that Mexico is a risky place to keep their savings they will move their capital to safe haven such as United States resulting in an increase in Mexican net capital outflow Consequently the demand for loanable funds in Mexico rises (moves to the right) in the market for loanable funds graph. This drives up the real interest rate Because net capital outflow is that hire for any interest rate that curve also shifts to the right in the net capital outflow the graph At the same time in the market for foreign currency exchange graph the supply of pesos rises so the line moves to the right and increase in supply of pesos causes the pesos to depreciate so the Paso becomes less valuable compared to other currencies

MV stands for

MV is the value of spending or transactions in an economy.

How net capital outflow depends on interest rate X axis, Y axis, supply, and demand

X- net capital outflow (net capital outflow is negative—-> 0 <—- net capital outflow is positive Y- real interest rate Supply——— Demand- slope downward

Y stands for

Y is real GDP.

the wealth effect summary

a lower price level increases real wealth, which stimulates spending on consumption

Real Variables and examples

Real variables are measured in quantity units, or adjusted for inflation. Examples include Y, M/P, r, W/P, and the relative price of wheat (Pw/PC).

public dissavings

When tax revenue is less than government spending, T < G, the government budget is in deficit (a budget deficit), which equals public dissavings. T < G=>BUDGET DEFICIT=>PUBLIC DISSAVINGS

Interpretation of real exchange rate

When the real exchange rate is high, the relative price of goods at home is higher than the relative price of goods abroad in this case import is likely because foreign goods are cheaper, in real terms, the domestic goods Thus when the real exchange rate is high, net exports decrease as imports rise

The market of loanable funds X and Y, and supply and demand

X-quantity of loanable funds Y- real interest rate Supply- supply of loanable funds (from national saving) Demand- demand for loanable funds (for domestic investment and net capital outflow)

Aggregate demand and aggregate supply graph X axis, Y axis, supply, and demand

X-quantity of output/ real GDP Y- price level Supply- aggregate supply Demand- aggregate demand

Factors that shift the SRAS curve: Physical Capital (K)

increase: Rightward decrease: Leftward

Factors that shift the SRAS curve: Price Expectations (Pe)

increase: Rightward decrease: Leftward

factors shifting AD curve: Autonomous investment (I)

increase: Rightward decrease: Leftward

factors shifting AD curve: Autonomous consumption (C)

increase: Rightward decrease: Leftward

factors shifting AD curve: Net Exports (NX)

increase: Rightward decrease: Leftward

Factors that shift the SRAS curve: Labor (L)

increase: right ward decrease: leftward

factors causing changes in the real exchange rate

1) Nominal exchange rate changes 2) Relative price levels change

trade policies do not affect

The trade balance

Stagflation

"Stag"- stagnant growth Economy is growing less than potential- high prices and no growth Decrease money supply-- AD leftward shift→ more economic downturn but price of things back down "Flation" - inflation

Real exchange rate computation

(Nominal exchange rate X Domestic price) / foreign price but if doing price index R = (e X P (price index of domestic item)) / P* (Price index of foreign item)

national savings

(Y - C - T) + (T - G) = S, where S is national savings. S = I + NX S - I = NX

Why might the aggregate demand curve shift?: changes in investment

- An event that causes firms to invest more at a given price level (optimism about the future, a fall in interest rates due to an increase in the money supply) shifts the AD curve to the right - An event that causes firms to invest less at a given price level (pessimism about the future, a rise in interest rates due to a decrease in the money supply) shifts the AD curve to the left

The exchange rate effect summary

A lower price level causes the real exchange rate to depreciate, which stimulates spending on net exports

What causes Stagflation

Caused by ^ price of inputs, particularly oil prices Oil prices rise significantly→ leftward shift SRAS (2 LRAS) If it's permanent to have effect of growth rate of economy

nominal exchange rate computation

Example, e = FC, where FC = Foreign Currency. $1 FC can be any Foreign Currency. For instance, € (euro) = €.66 $ $1 Could convert to $ = $1.51 (e.g., 1 = $1.51) € €1 ,66 €1 Yesterday € = €.71 ) Euro depreciated and $ appreciated $ $1 ) ) Today € = €.75 ) It takes more € to get $1 than before. $ $1 )

Public savings

G and T are the fiscal policy variables, or the government budget variables. When tax revenue exceeds government spending, T > G, the government budget is in surplus, which equals public savings. T > G=>BUDGET SURPLUS=>PUBLIC SAVINGS

M stands for

M is the money supply and determined by the Federal Reserve.

V stands for

V is velocity or the number of times a given $1 is used in a transaction over a given time period. Velocity can be computed as, V=(PY/M).

Factors that shift the SRAS curve: Technological Progress (A)

increase: Rightward decrease: Leftward

SRAS curve theories

classical misperceptions theory, sticky price and wage theory

factors shifting AD curve: Taxation (T)

decrease: Rightward increase: Leftward

nominal exchange rate computation

domestic price / foreign price

Factors that shift the SRAS curve: Human Capital (H)

increase: Rightward decrease: Leftward

It should be noted that the _______ determines the lender or debtor status of a nation.

position of NFI

AD curve theories

wealth effect, interest rate effect, exchange rate effect

Why does the aggregate demand curve slope downward?

wealth effect, interest rate effect, exchange rate effect

The interest rate effect summary

A Lower price level reduces the interest rate, which stimulates spending on investment

factors shifting AD curve: Money supply (M1)

increase: Rightward decrease: Leftward

Why might the aggregate demand curve shift?: changes in consumption

- an event that causes consumers to spend more at a given price level (a tax cut, a stock market boom, etc) shifts the AD curve to the right. - an event that causes consumers to spend less at a given price level (a tax hike, a stock market decline) shifts the AD curve to the left

Why might the aggregate demand curve shift?: changes in government purchases

- an increase in government purchases of goods and services (greater spending on defense or highway contraction) shifts the aggregate-demand curve to the right - a decrease in gov purchases on goods and services ( a cutback in defense or highway spending) shifts the AD curve to the left

Why might the aggregate demand curve shift?: changes in net exports

-and event that raises spending on net exports at given price level (a boom overseas, speculation that causes an exchange rate depreciation) shifts the aggregate demand curve to the right -an event that reduces spending on a net exports at a given price level (a recession overseas, speculation that causes an exchange rate appreciation) shift the aggregate demand curve to the left

factors shifting AD curve

1)Autonomous consumption (C) 2)Autonomous investment (I) 3)Government purchases (G) 4)Taxation (T) 5)Money Supply (M1) 6)Net Exports (NX)

Factors that shift LRAS curve

1)Labor (L) 2)Natural resources (N) 3)Physical capital (K) 4)Human capital (H) 5)Technological Progress (A) All when increased-shift Rightward

Factors that shift the SRAS curve

1)Labor (L) 2)Natural resources (N) 3)Physical capital (K) 4)Human capital (H) 5)Technological Progress (A) 6)Price expectations (Pe)

depreciation in real exchange rate

A depreciation (fall) in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods. This change encourages consumers both at home and abroad to buy more U.S. goods and fewer goods from other countries. As a result, U.S. exports rise and U.S. imports fall; both of these changes raise U.S. net exports.

What happens to the nominal exchange rate when inflation rates change

A higher inflation rate in the UK compared to other countries will tend to reduce the value of pound because: High inflation in the UK means that UK goods increase in price quicker than European goods. Therefore UK goods become less competitive. Demand for UK exports will fall, and therefore there will be less demand for Pound Sterling. Also, UK consumers will find it more attractive to buy European imports. Therefore they will supply pounds to be able to buy Euros and the Euro imports. This increase in the supply of pounds decreases the value of Pound Sterling. Therefore, in the long run, changes in relative inflation rates should lead to a change in the exchange rates.

Absolute PPP

Absolute PPP shows the long run movements in exchange rate to be described by movements in relative price ratios. Absolute PPP is described by the following equation, e=(P€/P$) If P€↑ (P$ constant) → e↑ → € depreciates and $ appreciates. If P$↑ (P€ constant) → e↓ → € appreciates and $ depreciates. The nominal exchange rate is determined by the relative price levels b/c you must trade currencies in order to trade goods and price levels determine trade flows.

Sticky wage theory

According to this theory, the short-run aggregate-supply curve slopes upward because nominal wages are slow to adjust to changing economic conditions. In other words, wages are "sticky" in the short run. To some extent, the slow adjustment of nominal wages is attributable to long-term contracts between workers and firms that fix nominal wages, sometimes for as long as 3 years. In addition, this prolonged adjustment may be attributable to slowly changing social norms and notions of fairness that influence wage setting. In short, according to the sticky-wage theory, the short-run aggregate-supply curve slopes upward because nominal wages are based on expected prices and do not respond immediately when the actual price level turns out to be different from what was expected. This stickiness of wages gives firms an incentive to produce less output when the price level turns out lower than expected and to produce more when the price level turns out higher than expected.

How net capital outflow depends on the interest rate

Because a higher domestic real interest rate makes domestic assets more attractive it reduces net capital outflow Note the position of zero on the horizontal axis: net capital outflow can be positive or negative A negative value of net capital outflow means that the economy is experiencing a net inflow of capital

The Effects of Capital Flight on an open economy in words summary

Capital flight from Mexico increases Mexican interest rates and decreases the value of Mexican pesos in the market for foreign currency exchange these price changes that result from capital flight influence some key macro economic quantities The depreciation of the currency makes exports cheaper and imports more expensive pushing the trade balance towards surplus at the same time the increase in the interest rate reduces domestic investment slowing capital accumulation and economic growth

appreciation of real exchange rate

Conversely, an appreciation (rise) in the U.S. real exchange rate means that U.S. goods have become more expensive compared to foreign goods, so U.S. net exports fall.

why NX=NCO

If NFI = NX, then, S = I + NFI [8] , OR S - I = NFI [9] When domestic savings, S, is greater than domestic private investment, I, NFI is greater than 0. When domestic, S, is less than domestic private investment, I, NFI is less than 0. This equation holds because every transaction that affects one side of this equation affects the other side by exactly the same amount. This equation is an identity—an equation that must hold because of how the variables in the equation are defined and measured. When a nation is running a trade surplus (NX > 0), it is selling more goods and services to foreigners than it is buying from them. What is it doing with the foreign currency it receives from the net sale of goods and services abroad? It must be using it to buy foreign assets. Capital is flowing out of the country (NCO > 0). When a nation is running a trade deficit (NX < 0), it is buying more goods and services from foreigners than it is selling to them. How is it financing the net purchase of these goods and services in world markets? It must be selling assets abroad. Capital is flowing into the country (NCO < 0).

what causes changes full-employment GDP in LRAS curve

If the overall price level has no impact on real GDP in the long-run, then what does? Since nominal variables are ruled out by monetary neutrality then it must be real variables that impact real GDP in the long-run. If we think back to the aggregate production function we can easily determine the real variables that impact real GDP in the long-run. These variables include technological progress (A), labor (L), natural resources (N), human capital (H), and physical capital (K). This is very logical since an increase in any of these real variables will lead to higher productivity levels (greater output potential) and thus improve the economy's potential growth rate, or increase full-employment GDP (and lower the NRU).

The effects of a government budget deficit in an open economy in summary

In an open economy, government budget deficits raise real interest rates, crowd out domestic investment, cause the currency to appreciate, and push the trade balance toward deficit

The real equilibrium in an open economy (the graphs all together)

In market for loanable funds The supply and demand for loanable funds determine the real interest rate In net capital outflow The interest rate determines net capital outflow which provides a supply of dollars in the market for foreign currency exchange In the market for foreign currency exchange The supply and demand for dollars in the market for foreign currency exchange determine the real exchange rate

Monetary Neutrality

Monetary neutrality proposes the neutrality of money in the long run. Money is neutral in the long run since it has no real effects, or has no impact on real variables in the long run. Monetary neutrality can be seen from the quantity theory of money equation. From this equation, a change in money only led to a change in another nominal variable, the price level. Since a change in money had no impact on the real variables (V or Y) it is neutral in the long run. The following expresses the monetary neutrality idea. ∆M=>nominal variables like P in the long run. ∆M does not impact real variables like V or Y in the long run.

Nominal Variables and examples

Nominal variables are measured in monetary units. Examples include PY, M, P, i, W and the price of wheat.

P stands for

P is the overall price level.

PY stands for

PY is nominal GDP or the value of output.

Relative PPP

Relative PPP shows the long run changes in the nominal exchange rate to be driven by inflation differentials. Relative PPP is described by the following equation, %∆e = Inflation€ - Inflation$ If INFLATION€ > INFLATION$ → € depreciates and $ appreciates. If INFLATION€ < INFLATION$ → € appreciates and $ depreciates.

Net debtor nation

S < I => NFI < 0. The country's domestic savings does not meet the desired domestic investment. The funds must flow into the US from other countries, thus NFI < 0. Therefore, US citizens are not purchasing as many foreign financial assets as foreign citizens are purchasing US assets. THE US IS NET DEBTOR NATION.

Net lender nation

S > I => NFI > 0. The country's excess savings (above desired domestic investment) will flow to other countries as more US citizens purchased relatively more foreign assets than foreign citizens purchase of US assets. THE US IS A NET LENDER NATION.

Why might the aggregate demand curve shift?

Shifts arising from changes in the consumption Changes in investment Changes in government purchases Changes in net exports

Real Exchange Rate

U.S. real exchange rate = the price of U.S. Goods relative to Foreign Goods (euro goods). The real exchange can be thought of as the terms of trade, or how expensive one countries goods are relative to another country's. The real exchange rate as defined below shows how expensive US goods are relative to Euro area goods. A rise in the real exchange rate as defined below is suggestive of US goods becoming more expensive relative to the Euro Area goods.

What happens to the nominal exchange rate when price levels change

That is, the nominal exchange rate equals the ratio of the foreign price level (measured in units of the foreign currency) to the domestic price level (measured in units of the domestic currency). According to the theory of purchasing-power parity, the nominal exchange rate between the currencies of two countries must reflect the price levels in those countries. the price level in any country adjusts to bring the quantity of money supplied and the quantity of money demanded into balance. Because the nominal exchange rate depends on the price levels, it also depends on the money supply and demand in each country. When a central bank in any country increases the money supply and causes the price level to rise, it also causes that country's currency to depreciate relative to other currencies in the world. In other words, when the central bank prints large quantities of money, that money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.

AD curve shape

The AD curve is downward sloping. The downward slope of the AD curve suggests that an inverse relationship exists between the overall price level and aggregate demand. To better understand this relationship we must recall that aggregate demand is made up of the four sectors of the economy (i.e. Y=C+I+G+NX). We can then use three theories to explain why an inverse relationship exists between the overall price level and HH consumption (C), business investment (I), and Net exports (NX). The theories follow. Government purchases (G) are made irrespective of the overall price level.

Shape of LRAS curve

The LRAS curve is vertical and rooted at full-employment GDP (YFE) The unemployment rate associated with this level of GDP is the natural rate of unemployment (NRU). The LRAS curve is vertical thus showing no relationship between the overall price level and real GDP in the long-run. What this implies is that a change in the overall price level (a nominal variable) will have no impact on real GDP (a real variable) in the long-run. This should sound very familiar because it is simply monetary neutrality. Recall that monetary neutrality is the proposition that a nominal variable will have no impact on a real variable in the long-run. It should be noted that monetary neutrality is a long-run proposition that must be relaxed to study the economy in the short-run. We will come back to this when we look at the shape of the SRAS curve.

Shape of SRAS curve

The SRAS curve is upward sloping thus showing a positive or direct relationship between the overall price level and real GDP (in the short-run). An increase in the overall price level gives each firm the incentive to increase output. In the short-run, therefore, nominal variables do have an impact on real variables. Thus, in the short-run variables are variables and there is no reason to distinguish between real and nominal variables (no classical dichotomy). Moreover, it is necessary to relax the idea of monetary neutrality to study the macroeconomy in the short-run.

classical dichotomy

The distinguishing between real and nominal variables is called the classical dichotomy. The classical economists realized the importance of making this distinction in order to understand how the economy functioned in the long run.

AD curve: exchange rate effect

The exchange rate effect explains why an inverse relationship exists between the overall price level and net exports (NX). It is as follows: P↓=>i↓=>E↓($ depreciates)=>NX↑=>Y↑ E=(Foreign currency/$) NX=Exports-Imports With the overall price level falling the cost of borrowing falls, i falls (Think i=r+P). Lower nominal interest rates in the US suggest relative higher returns in other countries (on financial instruments). To purchase these foreign financial instruments US citizens must supply US$'s in exchange for foreign currency. As a result of more US$'s being supplied to the world currency markets, the US dollar depreciates relative to other foreign currencies (FC). Net exports (NX) rise since US goods (US exports) have become relatively less expensive because the same unit of foreign currency will command a greater number of US $'s. The increase in NX then leads to an increase in real GDP (Y).

AD curve: interest rate effect

The interest rate effect explains why an inverse relationship exists between the overall price level and business investment (I). It is as follows: P↓=>i↓=>I↑=>Y↑ With the overall price level falling the cost of borrowing falls (Think i=r+P). Lower nominal interest rates lower the cost of borrowing which causes business investment (I) to increase and as a result real GDP (Y) increases.

The market of loanable funds

The interest rate in an open economy as in a close economy is determined by the supply and demand for loanable funds National saving is the source of supply of loanable funds Domestic investment and net capital outflow are the sources of the demand for loanable funds At the equilibrium interest rate the amount that people want to save exactly balances the amount that people want to borrow for the purpose of buying domestic capital and foreign assets

The effects of a government budget deficit in an open economy on graph

The market for loanable funds- A budget deficit reduces the supply of loanable funds which increases the real interest rate Net capital outflow- The higher interest rate reduces net capital outflow. reduced net capital outflow, in turn, reduces the supply of dollars in the market for foreign currency exchange (moves up in NCO demand line) The market for foreign currency exchange- this fall in NCO decreases the supply of dollars causes the real exchange rate to appreciate—> pushes trade balance toward a deficit

Quantity Theory of Money Equation

The quantity theory of money equation shows a long run proportional relationship between a change in the quantity of money and a change in prices. The quantity theory dates back to the classical economists including David Hume. The quantity theory of money equation is shown below, MV=PY

The market for foreign currency exchange

The real exchange rate is determined by the supply and demand for foreign currency exchange The supply of dollars to be exchanged into foreign currency comes from net capital outflow Because net capital outflow does not depend on the real exchange rate the supply curve is vertical The demand for dollars comes from net exports Because a lower real exchange rate stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net exports), the demand curve slopes downward At the equilibrium real exchange rate, the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports

the sticky price theory

The sticky-price theory emphasizes that the prices of some goods and services also adjust sluggishly in response to changing economic conditions. This slow adjustment of prices occurs in part because there are costs to adjusting prices, called menu costs. These menu costs include the cost of printing and distributing catalogs and the time required to change price tags. As a result of these costs, prices as well as wages may be sticky in the short run. because not all prices adjust immediately to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-desired prices, and these higher-than-desired prices depress sales and induce firms to reduce the quantity of goods and services they produce.

classical misperceptions theory SRAS

The upward slope of the SRAS has to do with the CLASSICAL MISPERCEPTION THEORY. Before discussing this theory it should first be noted that firms make decisions to increase output based on relative price changes as opposed to overall price level changes. Think of a relative price as the price of one good in terms of another good. For instance, we can get a relative price of wheat to corn, (Pw/Pc), by taking the price of wheat (Pw) and dividing it by the price of corn (Pc). Therefore if the relative price of wheat (to corn) increases we would expect producers to produce more wheat. Now to the theory! Assume there has been an increase in the overall price level (perhaps due to an increase in AD). Wheat producers, as well as other producers, misperceive this overall price increase as solely an increase in the relative price of wheat, or the relative price of the goods the other producers are producing. If this seems unimaginable, then think of each producer producing on an island and thus only knowing what is happening to the price of the product that is being produced. Because the wheat producer (as well as the other producers) misperceive an increase in the relative price of wheat the wheat producer will increase wheat production. Assuming that all producers behave in the same manner, we can logically reason that there is a positive relationship between the overall price level and real GDP in the short-run.

AD curve: wealth effect

The wealth effect explains why an inverse relationship exists between the overall price level and HH consumption. It is as follows: P↓=>(1/P)↑=>wealth↑=>C↑=>Y↑ With the overall price level falling the purchasing power of a given dollar increases. As result, the perceived wealth of the consumer rises along with HH consumption (C) and real GDP (Y).

nominal exchange rate

Value of one currency in terms of another. FC rates impact the economy because they affect trade and capital flows. It now takes more Euro to buy $1. The US$ has appreciated and the Euro has depreciated. The depreciating Euro has made US exports more expensive. It now takes the typical European €75 to buy the US good. Yesterday the US good cost only €71. The US$ has appreciated. The US$ appreciation has made the European good now less expensive since the US$ commands more Euro. When the US$ appreciates and the Euro depreciates the following will likely occur: U.S. exports↓ - U.S. imports↑ → ↓NX A stronger US$ will cause NX to decrease leading to a trade deficit.

Impact of trade policies (tariffs or quotas) in an open economy

When the us imposed a quota on the import of Japanese cars, nothing happens in the market for loanable funds in the market for loanable funds graph or to NCO in the NCO graph The only effect is a rise in net exports (exports-imports) for any given real exchange rate As a result, the demand for dollars in the market for foreign currency exchange rate rises—an import quota increases the demand for dollars and causes the real exchange rate to appreciate This appreciation of the dollar tends to reduce net exports, offsetting the direct effect of the import quota on the trade balance

The market for foreign currency exchange X axis, Y axis, supply, and demand

X- quantity of dollars exchanged into foreign currency Y- real exchange rate Supply- supply of dollars (from net capital outflow) Demand- demand of dollars (for net exports)

Open Economy identity equation

Y = C + I + G + NX Recall that national saving is the income of the nation that is left after paying for current consumption and government purchases. National saving (S) equals Y − C − G. If we rearrange the equation to reflect this fact, we obtain Y-C-G = I + NX S = I + NX Because net Because net exports (NX) also equal net capital outflow (NCO), we can write this equation as S = I + NCO The bottom line is that saving, investment, and international capital flows are inextricably linked. When a nation's saving exceeds its domestic investment, its net capital outflow is positive, indicating that the nation is using some of its saving to buy assets abroad. When a nation's domestic investment exceeds its saving, its net capital outflow is negative, indicating that foreigners are financing some of this investment by purchasing domestic assets.

private savings

Y-T-C When Domestic Savings, S, is greater than Domestic Private Investment, I, NX is greater than zero, NX>0 (a trade surplus). When Domestic Savings, S, is less than Domestic Private Investment, I, NX is less than zero, NX<0 (a trade deficit). SUMMARY, S > I => NX > 0 (trade surplus). S < I => NX < 0 (trade deficit).

the misperceptions theory

firms may confuse changes in P with changes in the relative price of the products they sell--> increase or decrease production/output

Factors that shift the SRAS curve: Natural Resources (N)

increase: Rightward decrease: Leftward

Hyperinflation

inflation that exceeds 50% per month The price level increases more than a hundredfold over the course of a year Data on hyperinflation: clear link between quantity of money and price level prices rise when the government prints too much money

NCO definition

net capital outflow the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners NCO=foreign assets purchased by US citizens - US assets purchased by foreign citizens Defining NET FOREIGN INVESTMENT (SOMETIMES CALLED NET CAPITAL OUTFLOWS),

NX definition

net exports the value of a nation's exports minus the value of its imports; also called the trade balance

Does Price expectations shift LRAS curve

no

What is inflation tax

revenue of the government raises by creating (printing) money Like a tax on everyone who holds money -when the government prints money -the price level rises -and the dollars in your wallet are less valuable

The Fisher Effect

shows the impact of changes in the money supply on interest rates i=r+Inflation can also be stated as follows to show the change in purchasing power of a savings vehicle. r=i-Inflation rate The Fisher equation shows a positive relationship between the inflation rate and the nominal interest rate: when inflation rate rises, so does the nominal interest rate. when the Fed increases the rate of money growth, the long-run result is both a higher inflation rate and a higher nominal interest rate

factors causing changes in real exchange rate: Relative price levels change

∆P$ or ∆P€ A change in P$ will change real exchange rates or a change in P€ will change the real exchange rate. Another example with P$ is 150, [U.S. goods are 1.065 times as ε = (€.71) (150) = 1.065 = 1.065 expensive as euro goods]. $1 100 1

factors causing changes in real exchange rate: Nominal exchange rate changes

∆e A change in the nominal exchange rate will cause the real exchange rate to change. Yesterday, ε = (€.71) (100) = .71 = .71 [U.S. goods are .71 times as expensive $1 100 1 as euro goods]. Today, ε = (€.75) (100) = .75 = .75 [U.S. goods are .75 times as expensive $1 100 1 as euro goods]. US goods are slightly more expensive than before b/c euro depreciated and U.S. $ appreciated.