Chapter 14: Exchange Rate and Purchasing Power Parity

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Purchasing Power Parity (PPP) Hypothesis

Nominal exchange rate will adjust so every country's currency has the same purchasing power

nominal exchange rate (e)

Relative price of two currencies Domestic currency/foreign currency

Depreciation of a currency

increase in nominal exchange rate decrease in import demand

changes in re (decrease)

domestic price level increases=price of domestic goods increases=real value of domestic currency increases=re decreases

real exchange rate (re)

Measures rate at which two countries's goods trade against each other re=e x (foreign price level/domestic price level)

changes in re (increase)

Foreign price level increases=price of foreign goods increases=real value of domestic currency falls=re increases nominal exchange rate increases=takes more domestic currency to buy foreign currency=real value of domestic currency falls=re increases

effective exchange rate

Trade-weighted nominal exchange rate EXAMPLE: Mexico's effective exchange rate e(eff)=aUSedollar+aEUeeuro aUS and aEU= weights that sum to 1 determine how e affects e(eff)

Exchange rate exposure

When a country does not enter a foreign market (via contracting or foreign investment) using their domestic currency

Appreciation of a currency

decrease in nominal exchange rate increase in import demand

PPP equation

nominal exchange rate=domestic price level/foreign price level

real effective exchange rate

re(eff)=aUSredollar+aEUreeuro


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