ECO2008 International Economics Week 13a
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Questions and Answers

What effect does an increase in the money supply have on nominal interest rates according to the Fisher effect?

An increase in the money supply leads to higher nominal interest rates due to the adjustment for the higher inflation rate.

Explain how the increase in nominal interest rates affects the demand for real monetary assets.

An increase in nominal interest rates decreases the demand for real monetary assets as they become less attractive compared to other investment opportunities.

What must happen in the money market to maintain equilibrium after an increase in the money supply?

Prices must increase to restore equilibrium in the money market following an increase in the money supply.

What does the concept of PPP imply regarding exchange rates in response to inflation?

<p>The concept of PPP implies that the exchange rate must adjust so that the price levels in different countries align, typically resulting in the depreciation of the domestic currency.</p> Signup and view all the answers

In the long run, how does inflation behave during the transition to equilibrium according to the model?

<p>Inflation is only predicted to occur during the transition to long-run equilibrium; it stabilizes at zero in the long run.</p> Signup and view all the answers

What is the relationship between domestic inflation and expected returns on foreign currency deposits?

<p>Higher domestic inflation expectations lead to increased expected returns on foreign currency deposits, causing the domestic currency to depreciate.</p> Signup and view all the answers

According to the monetary approach, what happens to domestic nominal interest rates when there is persistent domestic inflation?

<p>Persistent domestic inflation results in an increase in domestic nominal interest rates as adjusted by expectations of inflation.</p> Signup and view all the answers

How does the expected return on foreign currency deposits change during a period of rising inflation?

<p>The expected return on foreign currency deposits increases during periods of rising inflation, as investors expect better returns from foreign assets.</p> Signup and view all the answers

What happens to the price of U.S. goods relative to foreign goods during a real depreciation?

<p>The price of U.S. goods falls relative to foreign goods, making U.S. exports less expensive and imports more expensive.</p> Signup and view all the answers

How do increases in monetary levels affect nominal exchange rates?

<p>Increases in monetary levels lead to temporary inflation and changes in expectations about inflation, influencing nominal exchange rates.</p> Signup and view all the answers

What is the relationship between the relative demand for domestic products and the real exchange rate?

<p>Increases in the relative demand for domestic products lead to a real appreciation of the currency.</p> Signup and view all the answers

What occurs when there is an increase in the relative supply of U.S. products?

<p>An increase in the relative supply of U.S. products leads to a real depreciation of the currency.</p> Signup and view all the answers

What is the effect of nominal exchange rates when only monetary factors change and PPP holds?

<p>When only monetary factors change and Purchasing Power Parity (PPP) holds, there are no changes in the real exchange rate.</p> Signup and view all the answers

How does relative supply change influence real exchange rates?

<p>An increase in relative supply results in a depreciation of domestic goods in terms of price while increasing domestic output.</p> Signup and view all the answers

In what way do relative prices reflect the demand for U.S. goods?

<p>When U.S. exports become cheaper due to real depreciation, the demand for these goods increases relative to foreign imports.</p> Signup and view all the answers

How can changes in expectations about inflation affect the real exchange rate?

<p>Changes in expectations about inflation due to monetary growth lead to persistent inflation, influencing real exchange rates.</p> Signup and view all the answers

How does an increase in the U.S. money supply affect the nominal exchange rate $E$/€?

<p>It leads to a proportional increase in the nominal depreciation of the dollar.</p> Signup and view all the answers

What happens to the nominal exchange rate when there’s an increase in demand for U.S. output?

<p>The nominal exchange rate $E$/€ decreases, leading to an appreciation of the dollar.</p> Signup and view all the answers

What is the effect of an increase in the European money supply on the nominal exchange rate $E$/€?

<p>It results in a proportional decrease, leading to the nominal depreciation of the euro.</p> Signup and view all the answers

Describe the impact on nominal exchange rates when output supply increases in Europe.

<p>The effect is ambiguous, as it depends on various factors including demand and monetary policies.</p> Signup and view all the answers

What is the relationship between average domestic prices and foreign prices if real monetary asset demand increases?

<p>Average domestic prices are predicted to decrease relative to average foreign prices.</p> Signup and view all the answers

How does an increase in European money supply growth rate affect the nominal exchange rate $E$/€?

<p>It leads to a decrease in the nominal exchange rate, resulting in a nominal depreciation of the euro.</p> Signup and view all the answers

What does the Real Exchange Rate Approach indicate about nominal exchange rates?

<p>Nominal exchange rates are influenced by both Purchasing Power Parity and real output factors.</p> Signup and view all the answers

What occurs to the nominal exchange rate if there is an increase in demand for European output?

<p>There is an increase in the nominal exchange rate, leading to an appreciation of the euro.</p> Signup and view all the answers

What does the term 'long run' imply in the context of exchange rates and price adjustment?

<p>The 'long run' implies a sufficient amount of time for prices of all goods and services to adjust to market conditions, achieving equilibrium in the markets.</p> Signup and view all the answers

Explain the Law of One Price using the pizza price example provided.

<p>The Law of One Price states that identical goods should sell for the same price in different markets, as exemplified by a $20 pizza attracting buyers while a $40 pizza would not.</p> Signup and view all the answers

How would price adjustments occur if one restaurant sells pizza for $20 and another for $40?

<p>People would buy more pizzas from the cheaper restaurant, leading to increased demand and a price rise, while the expensive restaurant would see decreased demand, causing its price to drop.</p> Signup and view all the answers

Why do transportation costs and barriers matter in the Law of One Price?

<p>Transportation costs and barriers can prevent price equalization as they affect the ability of consumers to buy goods from the cheaper market.</p> Signup and view all the answers

What role do interest rates play in the long-run exchange rate models?

<p>Interest rates influence the behavior of currency exchange rates by attracting or repelling investment, affecting supply and demand for currencies.</p> Signup and view all the answers

What is the significance of competitive markets in the context of the Law of One Price?

<p>Competitive markets ensure that price differences trigger buyer behavior that leads to price adjustments, aligning prices across markets.</p> Signup and view all the answers

If the price of a pizza in Seattle is lower than in Vancouver, what market behavior can be expected?

<p>Consumers in Vancouver would likely travel to Seattle or have pizzas imported from there, increasing demand in Seattle and lowering supply in Vancouver.</p> Signup and view all the answers

How do upward and downward movements in supply and demand affect prices in the example of the pizza restaurants?

<p>An increase in demand or decrease in supply at the $20 restaurant would raise its price, while a decrease in demand or increase in supply at the $40 restaurant would lower its price.</p> Signup and view all the answers

What does Purchasing Power Parity (PPP) imply about exchange rates between countries?

<p>PPP implies that exchange rates are determined by the relative average prices of goods and services in different countries.</p> Signup and view all the answers

Using the provided price levels, calculate the implied exchange rate between Canadian and U.S. dollars if the price in the U.S. is US$200 and in Canada is C$400.

<p>The implied exchange rate is C$2/US$1.</p> Signup and view all the answers

Explain the difference between Absolute PPP and Relative PPP.

<p>Absolute PPP states that exchange rates equal the level of relative average prices, while Relative PPP measures how changes in exchange rates correspond to changes in inflation over time.</p> Signup and view all the answers

According to Relative PPP, what does the equation (E$ / €,t − E$ / €,t−1) = π US,t − π EU,t represent?

<p>It represents that changes in exchange rates are equal to the difference in inflation rates between two periods for the U.S. and the EU.</p> Signup and view all the answers

In the context of PPP, what would a higher price level in Canada compared to the U.S. suggest about the exchange rate?

<p>It suggests that the Canadian dollar would weaken relative to the U.S. dollar.</p> Signup and view all the answers

Why is it important for currencies to have the same purchasing power across countries according to PPP?

<p>It ensures fairness in international trade by allowing consumers to have equivalent purchasing power regardless of the currency used.</p> Signup and view all the answers

What would be the implications if the actual exchange rate diverges significantly from the PPP exchange rate?

<p>It may indicate that one country's goods are overpriced or underpriced in comparison to another, leading to potential trade imbalances.</p> Signup and view all the answers

If prices in the U.S. increase while prices in Canada remain constant, what effect would this have on the exchange rate according to PPP?

<p>The U.S. dollar would depreciate against the Canadian dollar.</p> Signup and view all the answers

How does higher domestic inflation affect the purchasing power of domestic currency compared to foreign currency?

<p>Higher domestic inflation decreases the purchasing power of domestic currency relative to foreign currency, leading to depreciation.</p> Signup and view all the answers

What occurs in the long-run model without purchasing power parity (PPP) when expectations of inflation adjust?

<p>The level of average prices does not immediately adjust, causing the exchange rate to overshoot and the domestic currency to depreciate more than its long-run value.</p> Signup and view all the answers

In the monetary approach that incorporates PPP, how does the level of average prices react to expectations of inflation?

<p>The level of average prices adjusts with expectations of inflation, resulting in domestic currency depreciation without overshooting.</p> Signup and view all the answers

What is the real exchange rate and how is it used to compare goods and services across countries?

<p>The real exchange rate is the rate of exchange for goods and services across countries, reflecting their relative value and price.</p> Signup and view all the answers

Using the formula qUS = (E $/€ * PEU) / PUS, explain what each variable represents.

<p>In this formula, <code>E $/€</code> is the nominal exchange rate, <code>PEU</code> is the price of the EU basket, and <code>PUS</code> is the price of the U.S. basket.</p> Signup and view all the answers

If the EU basket costs €100 and the U.S. basket costs $120 with an exchange rate of $1.20 per euro, what is the real exchange rate?

<p>The real exchange rate is 1 U.S. basket per 1 EU basket.</p> Signup and view all the answers

What does a real depreciation of U.S. products imply for their relative pricing compared to EU products?

<p>A real depreciation implies that U.S. goods become less expensive and less valuable relative to EU goods.</p> Signup and view all the answers

Define what overshooting means in the context of exchange rates.

<p>Overshooting refers to the phenomenon where the exchange rate moves beyond its long-run value due to temporary factors, such as sudden shifts in inflation expectations.</p> Signup and view all the answers

Study Notes

ECO2008 International Economics

  • Course title: International Economics
  • Topics covered: Price Levels and the Exchange Rate in the Long Run
  • Course material author: Brian Varian
  • Week: 13a

The Behavior of Exchange Rates

  • Exchange rate models from last week used movements in the money supply, both for short-run and long-run models, models developed further this week
  • Long-run models consider a sufficient time period for prices of all goods and services to adapt to market conditions and money markets
  • Changes in prices affect interest rates and exchange rates in long-run models

Law of One Price

  • The Law of One Price states that identical goods will sell at the same price in different (competitive) markets if transportation costs and barriers are unimportant.
  • Example: if a pizza costs $20 in one location and $40 in an identical store across the street, people will buy from the cheaper location until equilibrium
  • This incentivizes entrepreneurs to buy goods at lower prices and sell them at higher prices, until the price is the same in all competitive markets

Law of One Price (continued)

  • Entrepreneurs exploit price differences for profit, driving prices closer to equilibrium
  • Strong demand and low supply increases the price of a good
  • Weak demand and high supply decreases the price of a good
  • Prices adjust to be the same across all markets/locations (like identical pizza stores)

Law of One Price (continued)

  • Example: Pizza in Seattle and Vancouver; assuming no trade barriers, the price of identical pizzas must be the same in both cities, when using a common currency

Purchasing Power Parity

  • Purchasing Power Parity (PPP) is the extension of the law of one price to all goods and services across countries (e.g. basket of goods)
  • Pus = (EUS$/C$)(PCanada)
  • Pus = level of average prices in the U.S.
  • PCanada = level of average prices in Canada
  • EUS$/C$ = U.S. dollar/Canadian dollar exchange rate

Purchasing Power Parity (continued)

  • PPP implies an equilibrium exchange rate determined by average prices
  • Example: If US prices are $200 and Canadian prices are $400 for the same basket of goods, the exchange rate should be $400/$200=C$2/US$1

Purchasing Power Parity (continued)

  • Absolute PPP states exchange rates equal the level of relative average prices across countries
  • Relative PPP states changes in exchange rates equal changes in domestic and foreign prices

Monetary Approach to Exchange Rates

  • Monetary approach uses monetary factors to predict exchange rate adjustments in the long run
  • Levels of average prices across countries adjust until the quantity of real monetary assets supplied equals the quantity demanded
  • Formula: Pus = (MUS/L(RS, YUS)) / (PEU / L(REU, YEU))

Monetary Approach to Exchange Rates (continued)

  • Monetary factors like money supply and interest rates influence exchange rates
  • Change in domestic money supply leads to proportional price changes and exchange rate depreciation in the domestic currency (same as with PPP model)
  • Changing domestic interest rates influence real monetary asset demand, and associated with a rise in domestic prices, leading to currency depreciation

Monetary Approach to Exchange Rates (continued)

  • Output level changes influence real monetary asset demands, and average domestic prices (with fixed quantity of money supply) causing currency appreciation
  • All changes in money supply or demand affect prices in a way that matches the quantity of real monetary assets

Monetary Approach to Exchange Rates (Summary)

  • Change in domestic money supply leads to proportional price changes and exchange rate depreciation
  • Changing domestic interest rates influence real monetary asset demand, and associated with rising domestic prices, leading to currency depreciation
  • Output level changes influence real monetary asset demands and average domestic prices causing currency appreciation

The Fisher Effect

  • The Fisher Effect describes the relationship between nominal interest rates and inflation
  • Nominal interest rate difference between countries equals the difference in expected inflation rates
  • Rising domestic inflation causes an equal rise in the domestic interest rate (when holding other factors constant)

The Real Exchange Rate Approach

  • Economists generalize monetary approach to purchasing power parity to make a better theory
  • Real exchange rate is the relative value/price/cost of goods and services across countries (e.g. dollar price of European goods relative to American goods)
  • Real exchange rate influences nominal exchange rates

The Real Exchange Rate Approach (continued)

  • Change in relative demand for U.S. goods leads to real appreciation of the dollar relative to the euro
  • Change in relative supply of U.S. goods leads to real depreciation of the dollar relative to the euro

The Real Exchange Rate Approach (continued)

  • Monetary factors affect nominal exchange rates
  • Real factors also affect nominal exchange rates
  • Real exchange rate adjusts to match price/cost of goods

The Real Exchange Rate Approach (continued)

  • Increased relative demand of domestic products leads to real appreciation
  • Increased relative supply of US goods leads to real depreciation

The Role of Inflation and Expectations

  • Changes in money supply lead to changes in average price level
  • With PPP, persistent inflation leads to increase in domestic nominal interest rate
  • Expectations of high domestic inflation leads to depreciating domestic currency prior to period

Summary of Exchange Rate Approaches

  • Different approaches to exchange rate determination (e.g. the law of one price, purchasing power parity (PPP) monetary approach, real exchange rate approach)
  • Each accounts for various market factors including inflation, relative supply and demand, and monetary conditions.

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Explore the intricacies of exchange rates and the long-run models within international economics. This quiz delves into concepts such as the Law of One Price and how price levels influence market equilibrium. Test your understanding of these key economic principles covered in Brian Varian's course material.

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