Chapter 14: Exchange Rate and Purchasing Power Parity
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