Lecture 9 - Exchange rates and international finance

Question 1

What is the nominal exchange rate?

Answer 1

Price of one currency in terms of another (e.g., 154 yen/dollar).
↑E = Appreciation
↓E = Depreciation

Question 2

What is the Law of One Price?

Answer 2

Long-run equilibrium where EP = Pʷ
(Price in dollars × Exchange rate = Foreign price)
Arbitrage eliminates price differences for tradable goods

Question 3

What is the real exchange rate?

Answer 3

RER = (E×P)/Pʷ
Measures how many foreign goods one domestic good can buy.
Long-run RER = 1 (if Law of One Price holds)

Question 4

What drives short-run exchange rates?

Answer 4

1. Interest rate changes (↑i → ↑E)
2. Currency market supply/demand
3. Sticky prices make RER fluctuate with E

Question 5

What is the Policy Trilemma?

Answer 5

Countries can only achieve 2 of 3:
1. Stable exchange rates
2. Monetary autonomy
3. Free capital flows
Example: Eurozone sacrifices #2 for #1 and #3

Question 6

What caused the Euro Crisis?

Answer 6

1. Loss of monetary autonomy
2. No currency devaluation option
3. High sovereign debt (Greece >170% GDP)
4. ECB bond-buying programs as response

Question 7

What are euro advantages?

Answer 7

1. Eliminates exchange rate risk
2. Reduces transaction costs
3. Central bank credibility

Question 8

What are euro disadvantages?

Answer 8

1. No independent monetary policy
2. No regional adjustment via exchange rates
3. Fiscal policy constraints

Question 9

How do interest rates affect exchange rates?

Answer 9

↑iᴜˢ → Higher returns on USD assets → ↑Demand for USD → E appreciates
Short-run: Sticky prices amplify RER changes

Question 10

What determines long-run exchange rates?

Answer 10

Relative price levels: E = Pʷ/P
High inflation → Currency depreciation
(US vs. Japan example: 1960-2020)

Question 11

What is the Quantity Theory of Money?

Answer 11

M×V = P×Y → π* = gᴍ - gʏ
Long-run: Money growth determines inflation

Question 12

What are costs of inflation?

Answer 12

1. Wealth redistribution (lenders→borrowers)
2. Tax distortions
3. Relative price misallocation
4. Inflation tax (printing money)

Question 13

What is Ricardian Equivalence?

Answer 13

Timing of taxes doesn’t affect consumption if:
1. No financial frictions
2. Households anticipate future taxes
Implies limited fiscal stimulus effectiveness

Question 14

What is the government budget constraint?

Answer 14

G + Tr + iB = T + ΔB + ΔM
Intertemporal version: PDV(spending) + debt = PDV(taxes)

Question 15

What drives debt sustainability?

Answer 15

Debt/GDP falls when: i < g + π
(i = nominal interest, g = real growth, π = inflation)

Question 16

What is the twin deficits hypothesis?

Answer 16

Budget deficit (G>T) may correlate with trade deficit (NX<0) if private S = I

Question 17

What are currency union requirements?

Answer 17

1. Labor mobility
2. Fiscal transfers
3. Similar business cycles
   Eurozone lacked #2 exacerbating crises

Question 18

What is the yield curve?

Answer 18

Plot of interest rates vs. bond maturities.
Shows expected future short-term rates

Question 19

How do central banks control interest rates?

Answer 19

Open market operations:
Buy bonds → ↑Money supply → ↓i
Sell bonds → ↓Money supply → ↑i

Question 20

What is the classical dichotomy?

Answer 20

Long-run: Nominal variables (prices, money) don’t affect real variables (output, employment)
Fails in short-run due to sticky prices