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