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