Ch. 19

nominal bilateral exchange rates

'normal' spot exchange rate

why are we not good at predicting exchange rates?

(1) strong immediate reaction to new information; unexpected & cant be incorporated into models (2) exchange rate expectations can be formed without reference to economic fundamentals-- investors just extrapolate trends (bandwagon) - speculative bubbles

real exchange rate

(bilateral or effective) RER = (Pt/P0)*(et/e0)/(Pft/Pf0)*100 e here = foreign currency units per unit of domestic currency [(foreign cost of home currency) x (P/Pf) x (100)]. RER = nominal rate USD/EUR * average price of good in euro area/average price in USD

Suppose that back in 1990, the average level of prices in the North Pole was 100 and that in the South Pole was also 100. In the foreign exchange market at the time, one North Pole dollar (NPD) traded freely at par (1-to-1) with the South Pole dollar (SPD). By now, the price level in the North Pole has increased to 180 and that in South Pole has risen to 220. According to the absolute PPP theory, what should the two currencies' exchange rate be nowadays? 1 SPD = 1.222 NPD (220/180 = 1.222) 1 SPD = .818 NPD (180/220 = 0.818) 1 NPD = .818 SPD (180/220 = 0.818) 1 NPD = 1.222 SPD (220/180 = 1.222)

1 NPD = 1.222 SPD (220/180 = 1.222)

When did the modern era of floating exchange rates take hold?

1973

it takes _ years for deviation from PPP to be reduced by 1/2 for exchange rates of major industrialized countries

4

if currency is over priced relative to PPP standard, RER is

> 100, nominal exchange rate value higher than PPP value

All other things being equal, if the British government increases the money supply by 5% while the British economy is experiencing 5% real growth, the exchange rate on the pound will be A. unaffected. B. higher. C. lower. D. a mystery.

A

All other things being equal, which of the following would not cause the price of a foreign currency (e) to fall? A. A rise in the home country's expected inflation rate. B. A rise in the foreign country's expected inflation rate. C. A drop in the foreign country's real income. D. A rise in the foreign country's money supply.

A

Under the asset market approach, if both U.S. and British interest rates rise by three percentage points, we could expect A. the dollar to appreciate. B. the dollar to depreciate. C. the exchange rate between the dollar and the pound to remain unchanged. D. investors to move their funds to a third country.

C

If a country's nominal interest rate increases by the same percentage that the inflation rate has increased, A. international investors will withdraw their funds from the country. B. international investors will pour more funds into the country. C. international investors will demand an increase in the real interest rate they are paid. D. none of the above.

D

If there is a sudden five percent decrease in the domestic money supply, we should expect A. the domestic currency to appreciate by five percent in the long run. B. the domestic currency to appreciate by six percent in the short run. C. the foreign currency to depreciate as demand for foreign assets decreases. D. all of the above.

D

An increase in the domestic interest rate will cause the home currency to depreciate.

F

money supply =

K*P*Y (nominal/money value of GDP = price level & GDP) applies for domestic or foreign currencies)

increase in RER over time =

REAL appreciations

It was announced the two days ago that Australia's GDP growth picked up in the latest quarter by as much as analysts anticipated. The Governor of Australia's central bank commented that "our economy is doing relatively well compared with other countries, but it's not growing faster than we had expected." The most reasonable reaction in the foreign exchange market to the GDP news and the official comment would have been for the Australian dollar (AUD) to have: Appreciated Depreciated Remained Unchanged None of the Above

Remained unchanged

An expectation that the yen will appreciate can cause the yen to appreciate.

T

If the inflation rate in the United States is lower than the inflation rate in France, the euro will depreciate relative to the dollar.

T

International interest rate differentials drive exchange rates in the short run; international price differentials drive exchange rates in the long run.

T

The purchasing power parity hypothesis is unlikely to be true for countries that do not trade commodities internationally.

T

Suppose the average price of a Big Mac in the United States is $3.50 while in Japan the average price is 400 yen. If the market exchange rate is that 1 USD is exchanged for 100 JPY, the purchasing power-parity model of exchange-rate determination suggests that: The JPY is valued correctly. The JPY is overvalued and will depreciate against the USD. The USD is overvalued and will depreciate against the JPY. None of the above.

The JPY is overvalued and will depreciate against the USD.

if Switzerland wanted to maintain prices while they rose 10% elsewhere, they would have to..

accept a 10% increase in exchange rate value of currency

countries with relatively low inflation rates have currencies whose values tend to (appreciate/depreciate) in foreign exchange market

appreciate

Absolute Purchasing Power Parity

basket/bundle of products will have same cost in different countries if stated in same currency (essentially averaging law of one price) e=P/Pf

GDP deflator

broader coverage, varies annually/more current, includes non-consumer spending (not good measure of COL)

how should policies react to inflation?

depends on the cause of inflation- can be contractionary exchange-rate fix price setting :( influence expectations

fast money growth + stagnant real economy, currency likely [depreciating/appreciating]

depreciating

high inflation rate = [appreciating/depreciating]

depreciating, approximately equal to percentage point difference in relevant inflation rates

Relative Purchasing Power Parity

difference between changes over time in produce price levels in two countries will be offset by change in exchange rate over time (et/e0) = (Pt/P0)/(Pft/Pf0) exchange rate year (T) over exchange rate year 0 EQUALS increase in domestic price from year 0 to year T over increase in foreign price from year 0 to year T approximation: rate of appreciation of foreign currency: π-πf (product-price inflation rates for domestic & foreign countries)

in the long term, why do some currencies appreciate and some depreciate?

difference in national rates of inflation; concept of purchasing power parity

monetary approach to exchange rates

emphasizes importance of money demand & supply

asset market approach to exchange rates

emphasizes rate of portfolio repositioning by international financial investors

when should market rates be used to measure size of economy?

for financial flows

cut in money supply ->

higher exchange rate value of the currency

how is inflation measured?

household surveys determine basket of items & cost of purchasing them mainly rent/mortgage consumer price index

Does RPPP hold?

if APPP holds for both Y0 and YT, otherwise still useful guide for why exchange rates change over time.

Does APPP hold?

if LoOP holds, APPP holds - even if LoOP doesn't, APPP might (different products balance each other) In the real world, APPP doesn't work much better because of technical difficulties

law of one price

in perfectly competitive global market, product that is easily & freely traded should have same price everywhere P = e * Pf

increased incomes --> [increased/decreased] value of currency

increased

what is hyperinflation?

inflation > 1000%

[short term] if expected future spot exchange rate decreases...

international financial repositioning toward domestic currency assets → spot exchange rate decreases (domestic currency appreciates)

[short term] if foreign interest rate decreases...

international financial repositioning toward domestic currency assets → spot exchange rate decreases (domestic currency appreciates)

if domestic interest rate decreases...

international financial repositioning toward foreign currency assets → exchange rate increases (domestic currency depreciates)

[short term] if expected future spot exchange rate increases...

international financial repositioning toward foreign currency assets → spot exchange rate increases (domestic currency depreciates)

[short term] if foreign interest rate increases...

international financial repositioning toward foreign currency assets → spot exchange rate increases (domestic currency depreciates)

if domestic interest rate increases...

international financial repositioning → domestic currency assets, exchange rate ↓ (domestic currency appreciates)

what creates expectations for future spot exchange rate?

investors may expect recent trends to continue (bandwagon- this speculation can be destabilizing) may believe exchange rates will return to values consistent with basic economic conditions (this can be stabilizing) unexpected conditions → reaction

if there is an unexpected increase in country's trade deficit or current account deficit and foreign financing isn't assured to be forthcoming, what happens to currency in foreign exchange market?

it decreases, increasing demand for foreign currency to pay for excess of imports will cause domestic currency to depreciate.

what determines national price level/inflation rat?

long run - money supply (therefore also exchange rates)

PPP holds well in the [short/long] run, not in the [short/long] run

long, short

is inflation good or bad for an economy?

low, stable, predictable inflation is best

purchasing power parity

money as a determinant of national product price levels & inflation rates basis: people choose to buy goods & services based on price they'll pay

quantity theory equation

money supply = demand for money; directly proportional to money value of GDP m=kPY

e = p/pf =

ms/msf * kf/k * yf/y

p/pf =

ms/msf * kf/k * yf/y

supply shocks

natural disasters, etc (disrupt production); high oil prices, etc (increase production prices) ↓ overall supply → cost-push inflation

how well can we predict exchange rates in the short run?

no better than random walk

how does short run flow into long run?

overshooting - international investors form expectations of future exchange rates partly on believe that exchange rates will move toward fundamentals, react rationally to news that exchange rate moves past expectation this makes the exchange rate move back. product prices are relatively sticks in the short run increase in money supply drives down domestic interest rate with lower domestic interest rate, favor shifts to foreign currency assets, increased demand for foreign currency → appreciation of foreign currency

what is wrong with comparing prices using exchange rates?

overstate disparity between rich & poor nations price difference ratio is above unite for most industrialized countries non-traded products (e.g. houses & haircuts) differ radically -- land in lower income countries is cheaper, highly sensitive to income as country develops, productivity in making traded goods expands faster

why is deflation bad?

people delay making purchases if they expect deflation, which means there is less economic activity

how does the expected future spot exchange rate play a role in the short term?

self-confirming expectations -- if investors expect future spot exchange rate to be higher than previously expected, there is a shift in favor of foreign currency denominated bonds, demand for foreign currency ↑, spot exchange rate ↑, domestic currency depreciates.

how well can we predict exchange rates in the long run?

slightly better than in the short run

foreign nation will have appreciating currency if some combination of:

slower money growth; faster growth in real output; rise in ratio kf/k

what are benefits of PPP rates for measuring size of economy?

stable, relevant for non-traded goods- BUT harder to measure

core consumer inflation

underlying persistent trends, more volatile prices of products like food, energy, most affected by seasonal factors/temporary supply

If it suddenly looks like domestic interest rates are going to drop more than previously expected, while foreign interest rates and the expected future spot rate remain unchanged, then chances are that the domestic currency's exchange rate will: Strengthen. Weaken. Remain unchanged. Converge to its PPP value.

weaken

nominal effective exchange rate

weighted average spot exchange rate

does the law of one price hold?

well for heavily traded commodities if free trade is permitted (gold & other metals; crude oil; various agricultural commodities) doesn't hold for most products, nearly all manufactured goods because of transport costs, unfree trade, imperfectly competitive markets, dumping

e ^ 1% for each 1%

↑ in domestic money supply ↓ in foreign money supply ↓ in domestic real GDP ↑ in foreign GDP unaffected by BALANCED growth

(according to asset market approach) exchange rate value of foreign currency (e) is raised in the short run by what?

↑ in foreign interest rate relative to our interest rate ↑ in expected future spot rate

(according to monetary approach to exchange rates) spot exchange rate raised in LONG RUN by:

↑ in our money supply relative to foreign money supply ↑ in foreign real domestic product relative to our real domestic product