Lectures 21-23

Question 1

Absolute Purchasing Power Parity (APPP)

Answer 1

P=SP*
States “The general level of prices when converted to a common currency will the same in every country”

Question 2

Consumer Price Index (CPI)

Answer 2

Weighted average of individual product prices, with weights determined by expenditure shares. Assumes weights going into CPI are identical in domestic and foreign countries

Question 3

Purchasing Power Parity (PPP)

Answer 3

Analyses exchange rate movements

Question 4

If PPP holds at all time, what happens to competitiveness

Answer 4

Competitiveness equalised, no country has general price advantage over others.

Question 5

Theory of Exchange rate determination

Answer 5

If exchange rate is 0.75 (1USD=0.75GBP), expect actual S to be 0.75 in LR. If we find its actually:
0.9 - GBP undervalued, need to appreciate
0.5 - GBP overvalued and needs to depreciation

Question 6

When currency is undervalued

Answer 6

• Exports cheaper in foreign markets
• Imports more expensive for households

Question 7

When currency is overvalued

Answer 7

• Exports more expensive in foreign markets
• Imports cheaper for households

Question 8

Real Exchange Rate (Q)

Answer 8

Price of foreign relative to domestic, nominal exchange rate corrected for relative prices
Q=SP*/P

Question 9

What does Q measure?

Answer 9

Purchasing power of a unit of foreign currency in foreign economy relative to purchasing power of equivalent unit of domestic currency in domestic economy

Question 10

Relative PPP

Answer 10

Logs of P=SP(^star), use lowercase p=s+p(^star)

Question 11

Derivate of ln gives proportional rate of change d(log P)=

Answer 11

d(log P)=dp=dP/p

Question 12

dp=ds+dp* OR

Answer 12

dp-dp*=ds (Relative PPP)

Question 13

When domestic country has higher inflation than foreign,

Answer 13

S should depreciate (this is relative PPP)

Question 14

Balassa-Samuelson Hypothesis: Types of goods & sectors

Answer 14

• Traded goods - manufacturing sector
• Non-traded goods - services sector

Question 15

What does the Balassa-Samuelson Hypothesis suggest?

Answer 15

General Price Level is higher in rich countries due to higher price of non-traded services

Question 16

Balassa-Samuelson Hypothesis: Wages in ____ sector rise faster than ____ sector

Answer 16

goods; non-traded goods

Question 17

If domestic grows faster than foreign

Answer 17

Non-traded to traded goods price ratio grows faster than foreign’s. Price level of domestic grows faster than foreign, meaning Q is falling (real exchange rate appreciating)

Question 18

Balassa-Samuelson Hypothesis: what does it predict

Answer 18

Fast growing developing countries should experience an appreciation of their currencies.

Question 19

Most important exception to PPP

Answer 19

Existence of non-tradeable goods

Question 20

PPP exchange rate is frequently ____ than market exchange rate for developing countries

Answer 20

Lower

Question 21

If Big Mac costs 5 USD and 25 yuan RMB with an exchange rate of 7, is China’s currency accurately valued

Answer 21

It is undervalued, meaning China’s exchange rate should be 5

Question 22

When are PPP exchange rate not suitable?

Answer 22

Comparing exchange rate between developed and developing countries

Question 23

Financial Markets in Open Economy: Domestic

Answer 23

Invest 1 GBP into 12 month fixed deposit, receive GBP(1+r)

Question 24

Financial Market: Steps for foreign

Answer 24

1. Convert GBP into USD
2. Deposit in US bank
3. Convert back at end of year

Question 25

Financial Market: what (formula) is achieved at every step of the way

Answer 25

1. US 1/S 2. US 1(1/S)(1+r*) (*=foreign variable) 3. GBP (1+r*)S^e/S

Question 26

Risk Premium

Answer 26

Reward to persuade to bear risk

Question 27

Uncovered Interest Rate Parity: Formula

Answer 27

(1+r)=(1+r*)S^e/S

Question 28

Uncovered interest parity relation

Answer 28

r=r*+Δs^e

Question 29

Covered interest parity formula

Answer 29

(1+r)=(1+r^star)(1+f) OR r=r^star+f

Question 30

Carry Trade Paradox

Answer 30

Borrowing from low interest rate currency and lending in high interest rate currency

Question 31

When is Carry Trade profitable

Answer 31

In Good years (little change in exchange rates). There are more good than bad years, meaning it is a profitbale strategy.

Question 32

Trade theory: Absolute Advantage

Answer 32

If cheaper to produce good X in country A and Y in country B, each country has an absolute advantage in producing their product

Question 33

Comparative Advantage defined through...

Answer 33

Opportunity Cost

Question 34

When does a country have a comparative advantage over another?

Answer 34

When the opportunity cost of producing a good in the country is lower than the other country

Question 35

If both countries specialise in what they have comparative advantages in, what does this achieve?

Answer 35

Trade would allow for point beyond the PPF

Question 36

Difference in PPF slopes shows

Answer 36

Difference in comparative advantage

Question 37

Terms of Trade (ToT)

Answer 37

Ratio between index of export and index of import prices

Question 38

What does a positive ToT signify?

Answer 38

Export prices increase more than import, meaning can purchase more imports

Question 39

Sources of comparative advantage

Answer 39

- Economies of Scale

Question 40

2 Components of total global income inequality

Answer 40

1. Inequality between countries 2. Inequality within countries

Question 41

What is most global inequality caused by in modern day?

Answer 41

Difference in income between countries

Question 42

What is the Lakner-Milanovic graph also called?

Answer 42

Elephant Chart

Question 43

What does the Lakner-Milanovic graph show?

Answer 43

Winners and losers in global economy over last several decade