Real exchange rates

Question 1

What is the law of one price?

Answer 1

- A good should cost the same abroad and at home

Where:

PPP = price purchasing power

domestic curreny price of good i

forgein currency price of good i

nominal exchange rate (domestic currency price of 1 unit of foreign currency)

Question 2

What are the reasons LOOP may fail?

Answer 2

1. A good has non-traded inputs(e.g. goods that can’t be transported, or aren’t homogenous - labour, rent, electricity)
2. Government policies/regulations(taxes)
3. Barriers to trade(tariffs, quotas)
4. Pricing to market(pharmaceuticals)

Question 3

What is the real exchange (in maths + words)

Answer 3

Real exchange rate:

= no. of units of domestic currency that can purchase a given foreign currency

Question 4

If , what does that mean?

Answer 4

The home basket is undervalued, or forgein basket is over valued

Question 5

If , what does that mean?

Answer 5

The home basket is overvalued, or foreign basket is undervalued

Question 6

If real interest rate increases, is this a depreciation or apreciation, and what does this mean?

Answer 6

Depreciation - home basket becomes more undervalued

Question 7

If real interest rate decreases, is this a depreciation or apreciation, and what does this mean?

Answer 7

Appreciation - home basket becomes more overvalued

Question 8

What is absolute price purchasing power?

(maths + words)

Answer 8

When e=1

Can buy the exact same good basket in each country for the same price

Question 9

What is relative price purchasing power?

(maths + words)

Answer 9

Exchange rates do not change - can buy the same relative basket

Question 10

Does relative PPP hold, and how do we test this?

Answer 10

long run relative PPP holds, but short-term e is volatile + relative PPP does not hold

Test 1: if relative PP holds then: -

• Compare CPI indexes - should find co-movement

Test 2:

real exchange rate = inflation aboard – domestic inflation + nominal exchange rate appreciation / depreciation

If relative PPP holds, then in the long run:

difference between foreign and domestic long run inflation = rate of depreciation of the exchange rate

- plot inflation differentials against exchange rate + should find a 1-1 (45^o) relationship

Question 11

Does Absolute PPP hold, and how do we test this?

Answer 11

Absolute PPP does not hold

Test 1: does absolute PPP hold for a single good – Big Mac Index

if absolute PPP holds, then

à were high for rich countries and low for poor countriesàabsolute PPP fails

Test 2: International Comparison Program (ICP)

Reports price level (one studies 1970s and 2011) àAbsolute PPP fails!

Question 12

How can we tell if a currency is over/under valued?

Answer 12

= the PPP exchange rate (nominal exchange rate that makes PPP hold)

then - $ is overvalued (or foreign currency is undervalued)

then - $ is undervalued (or foreign currency is overvalued)

Question 13

Why does PPP fail?

Answer 13

Many goods aren’t/can’t be traded internationallyp differences aren’t arbitraged away via trade

Question 14

What are the assumptions in Balassa-Samuelson’s model?

Answer 14

1. is homogenous of degree 1 (scale inputs = scale output) e.g. a Cobbdogglas
2. Suppose LOOP holds for traded goods but not for nontraded goods:

Question 15

Dervive of Balassa-Samuelson’s Model

Answer 15

à through by or and then by them -

If LOOP for traded goods holds -

Question 16

Using Balassa-Samuelson’s model: If what happens to the real exchange rate?

Answer 16

e increases - aka real exchagne rate depreciates

Question 17

What is the main take away from Balassa-Samuelson’s model?

Answer 17

Countries with higher productivity growth in tradables compared to non-tradables have higher prices + real exchange rate appreciates

Question 18

Derive of Balassa-Samuelson’s Model

Answer 18

- FOC: - MR=MC

- FOC: - MR=MC

Question 19

What does mean?

Answer 19

The relative prices of nontradables in term of tradables = inverse of the ratio of labour productivity of nontradables to tradables – aka more productive = lower price

Question 20

If change in < change in what happens to the real exchange rate?

Answer 20

Real exchagne rate decreases - aka it appricates