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Questions and Answers
What does the absolute Purchasing Power Parity (PPP) hypothesis imply about the real exchange rate?
What does the absolute Purchasing Power Parity (PPP) hypothesis imply about the real exchange rate?
- The real exchange rate depends on inflation rates.
- The real exchange rate is always less than 1.
- The real exchange rate can vary widely.
- The real exchange rate is equal to 1. (correct)
What is the implication of Relative PPP for the nominal exchange rate when foreign inflation is greater than domestic inflation?
What is the implication of Relative PPP for the nominal exchange rate when foreign inflation is greater than domestic inflation?
- The real exchange rate increases.
- The domestic currency depreciates.
- The domestic currency remains unchanged.
- The domestic currency appreciates. (correct)
In the long run, what is primarily reflected in the nominal exchange rate?
In the long run, what is primarily reflected in the nominal exchange rate?
- Interest rate differentials.
- Changes in foreign reserves.
- Short-term market fluctuations.
- Price level differences. (correct)
Which statement accurately describes the relationship between Absolute PPP and Relative PPP?
Which statement accurately describes the relationship between Absolute PPP and Relative PPP?
What is a characteristic of countries with low and stable inflation regarding their exchange rates?
What is a characteristic of countries with low and stable inflation regarding their exchange rates?
What condition must hold for the real exchange rate to remain constant according to Relative PPP?
What condition must hold for the real exchange rate to remain constant according to Relative PPP?
What primarily drives changes in the real exchange rate in the short run?
What primarily drives changes in the real exchange rate in the short run?
When discussing fluctuations in the real exchange rate with a fixed nominal exchange rate, what is the expected behavior?
When discussing fluctuations in the real exchange rate with a fixed nominal exchange rate, what is the expected behavior?
What does an increase in the nominal exchange rate E indicate regarding the AUD and USD?
What does an increase in the nominal exchange rate E indicate regarding the AUD and USD?
Which statement correctly describes fixed exchange rate regimes?
Which statement correctly describes fixed exchange rate regimes?
How is the real exchange rate (RER) calculated?
How is the real exchange rate (RER) calculated?
What happens when the real exchange rate (RER) is greater than 1?
What happens when the real exchange rate (RER) is greater than 1?
What primarily drives the supply of domestic currency in foreign exchange markets?
What primarily drives the supply of domestic currency in foreign exchange markets?
Which of the following describes the purpose of exchange rates in an economy?
Which of the following describes the purpose of exchange rates in an economy?
What does it imply if RER < 1?
What does it imply if RER < 1?
What can cause a shift in the demand for domestic currency?
What can cause a shift in the demand for domestic currency?
Which of the following statements about nominal exchange rates is correct?
Which of the following statements about nominal exchange rates is correct?
An appreciation of a currency usually results from which of the following?
An appreciation of a currency usually results from which of the following?
Which factor can increase the demand for foreign currencies?
Which factor can increase the demand for foreign currencies?
Which aspect of exchange rates does purchasing power parity focus on?
Which aspect of exchange rates does purchasing power parity focus on?
What is the equilibrium nominal exchange rate dependent on?
What is the equilibrium nominal exchange rate dependent on?
A flight to safety in times of market turbulence typically leads to what effect on domestic currency?
A flight to safety in times of market turbulence typically leads to what effect on domestic currency?
Exchange rate determination through supply and demand models encompasses which of the following concepts?
Exchange rate determination through supply and demand models encompasses which of the following concepts?
What type of economic condition can lead to changing demand patterns for domestic goods and services?
What type of economic condition can lead to changing demand patterns for domestic goods and services?
What effect does a decrease in the real exchange rate have on foreign and domestic goods?
What effect does a decrease in the real exchange rate have on foreign and domestic goods?
Which factors contribute to the change in the real exchange rate as represented in the formula gRER = gE + gP − gP f?
Which factors contribute to the change in the real exchange rate as represented in the formula gRER = gE + gP − gP f?
What distinguishes a floating exchange rate from a fixed exchange rate?
What distinguishes a floating exchange rate from a fixed exchange rate?
How is a fixed exchange rate maintained by policy-makers?
How is a fixed exchange rate maintained by policy-makers?
What is the Law of One Price primarily associated with?
What is the Law of One Price primarily associated with?
What does a currency union represent in terms of exchange rate regime?
What does a currency union represent in terms of exchange rate regime?
What happens to the exchange rate regime if reserves are exhausted?
What happens to the exchange rate regime if reserves are exhausted?
Which of the following is NOT a typical characteristic of a managed float exchange rate?
Which of the following is NOT a typical characteristic of a managed float exchange rate?
A decrease in the real exchange rate (RER) makes foreign goods more expensive and domestic goods cheaper.
A decrease in the real exchange rate (RER) makes foreign goods more expensive and domestic goods cheaper.
In a currency union, the price of currency is fixed in terms of foreign currency.
In a currency union, the price of currency is fixed in terms of foreign currency.
Purchasing Power Parity (PPP) implies that tradeable goods should sell for different prices across different markets.
Purchasing Power Parity (PPP) implies that tradeable goods should sell for different prices across different markets.
A floating exchange rate is determined solely by government policy.
A floating exchange rate is determined solely by government policy.
The change in real exchange rate can occur even if the nominal exchange rate is fixed.
The change in real exchange rate can occur even if the nominal exchange rate is fixed.
Crisis occurs when the current exchange rate regime has strong credibility.
Crisis occurs when the current exchange rate regime has strong credibility.
A fixed exchange rate is maintained only by the buying and selling of gold.
A fixed exchange rate is maintained only by the buying and selling of gold.
An increase in the nominal exchange rate indicates a strengthening of the domestic currency.
An increase in the nominal exchange rate indicates a strengthening of the domestic currency.
An increase in the nominal exchange rate E results in the depreciation of the AUD against the USD.
An increase in the nominal exchange rate E results in the depreciation of the AUD against the USD.
Real exchange rates indicate the relative price of a consumption basket in terms of another currency.
Real exchange rates indicate the relative price of a consumption basket in terms of another currency.
Absolute Purchasing Power Parity (PPP) implies that the real exchange rate is approximately constant.
Absolute Purchasing Power Parity (PPP) implies that the real exchange rate is approximately constant.
In a fixed exchange rate regime, monetary policy is very effective at influencing domestic demand.
In a fixed exchange rate regime, monetary policy is very effective at influencing domestic demand.
If foreign inflation is lower than domestic inflation, the domestic currency will appreciate.
If foreign inflation is lower than domestic inflation, the domestic currency will appreciate.
When the real exchange rate (RER) is greater than 1, foreign goods appear expensive in real terms.
When the real exchange rate (RER) is greater than 1, foreign goods appear expensive in real terms.
The bilateral nominal exchange rate can be expressed as either a direct quote or an indirect quote.
The bilateral nominal exchange rate can be expressed as either a direct quote or an indirect quote.
Relative PPP involves changes in the nominal exchange rate being equal to the inflation differential between two countries.
Relative PPP involves changes in the nominal exchange rate being equal to the inflation differential between two countries.
Purchasing power parity suggests that nominal exchange rates do not reflect relative price levels between countries.
Purchasing power parity suggests that nominal exchange rates do not reflect relative price levels between countries.
In the long run, exchange rates are influenced primarily by short-run fluctuations.
In the long run, exchange rates are influenced primarily by short-run fluctuations.
Under fixed nominal exchange rates, the real exchange rate is more volatile compared to floating nominal exchange rates.
Under fixed nominal exchange rates, the real exchange rate is more volatile compared to floating nominal exchange rates.
An appreciation in the real exchange rate corresponds to a decrease in the price of foreign goods, making them relatively more expensive.
An appreciation in the real exchange rate corresponds to a decrease in the price of foreign goods, making them relatively more expensive.
Exchange rates can significantly influence international capital flows and interest rates between countries.
Exchange rates can significantly influence international capital flows and interest rates between countries.
A depreciation of the domestic currency occurs when foreign inflation is greater than domestic inflation.
A depreciation of the domestic currency occurs when foreign inflation is greater than domestic inflation.
The Law of One Price applies to individual goods but not to the whole consumption basket.
The Law of One Price applies to individual goods but not to the whole consumption basket.
In the short run, real exchange rate variations are primarily linked to changes in the nominal exchange rate.
In the short run, real exchange rate variations are primarily linked to changes in the nominal exchange rate.
Increased demand for foreign goods and services can lead to a higher supply of domestic currency.
Increased demand for foreign goods and services can lead to a higher supply of domestic currency.
Demand for domestic currency decreases when foreign households want to buy domestic goods and services.
Demand for domestic currency decreases when foreign households want to buy domestic goods and services.
Higher national GDP generally leads to changing patterns of expenditure and increased demand for domestic goods.
Higher national GDP generally leads to changing patterns of expenditure and increased demand for domestic goods.
The equilibrium nominal exchange rate is established when the supply of domestic currency equals the demand for foreign currency.
The equilibrium nominal exchange rate is established when the supply of domestic currency equals the demand for foreign currency.
In times of market turbulence, investors tend to shift to investing in foreign assets.
In times of market turbulence, investors tend to shift to investing in foreign assets.
Changing tastes can influence the demand for foreign assets.
Changing tastes can influence the demand for foreign assets.
A flight to safety usually increases the demand for domestic goods and assets.
A flight to safety usually increases the demand for domestic goods and assets.
Expenditure patterns change primarily due to fluctuations in nominal exchange rates.
Expenditure patterns change primarily due to fluctuations in nominal exchange rates.
How does a decrease in the real exchange rate (RER) impact imports and exports?
How does a decrease in the real exchange rate (RER) impact imports and exports?
What factors can lead to changes in the real exchange rate according to the formula gRER = gE + gP − gP f?
What factors can lead to changes in the real exchange rate according to the formula gRER = gE + gP − gP f?
What is one key characteristic of a floating exchange rate regime?
What is one key characteristic of a floating exchange rate regime?
What occurs if policy-makers exhaust their reserves in a fixed exchange rate regime?
What occurs if policy-makers exhaust their reserves in a fixed exchange rate regime?
What does the Law of One Price imply about traded goods in different markets?
What does the Law of One Price imply about traded goods in different markets?
In the context of currency appreciation, what does an increase in the nominal exchange rate E signify?
In the context of currency appreciation, what does an increase in the nominal exchange rate E signify?
What is the main difference between nominal and real exchange rates?
What is the main difference between nominal and real exchange rates?
What is a currency union, and how does it relate to exchange rate regimes?
What is a currency union, and how does it relate to exchange rate regimes?
How does a fixed exchange rate regime affect a country's monetary policy?
How does a fixed exchange rate regime affect a country's monetary policy?
How does inflation affect the real exchange rate based on the relationship between domestic and foreign inflation rates?
How does inflation affect the real exchange rate based on the relationship between domestic and foreign inflation rates?
What does an increase in the bilateral nominal exchange rate indicate about the currencies involved?
What does an increase in the bilateral nominal exchange rate indicate about the currencies involved?
What happens to foreign goods when the real exchange rate (RER) is greater than 1?
What happens to foreign goods when the real exchange rate (RER) is greater than 1?
In terms of supply and demand, what primarily drives short-run fluctuations in exchange rates?
In terms of supply and demand, what primarily drives short-run fluctuations in exchange rates?
How is purchasing power parity (PPP) related to the long-term exchange rates?
How is purchasing power parity (PPP) related to the long-term exchange rates?
What happens when there is greater domestic inflation compared to foreign inflation in terms of exchange rates?
What happens when there is greater domestic inflation compared to foreign inflation in terms of exchange rates?
What is the expected impact on capital flows when there are anticipated changes in exchange rates?
What is the expected impact on capital flows when there are anticipated changes in exchange rates?
Explain how the concept of Absolute Purchasing Power Parity relates to overall consumption baskets between countries.
Explain how the concept of Absolute Purchasing Power Parity relates to overall consumption baskets between countries.
What is the implication of Relative PPP when it comes to the relationship between inflation rates in two countries?
What is the implication of Relative PPP when it comes to the relationship between inflation rates in two countries?
Discuss the long-term and short-term implications of purchasing power parity on nominal exchange rates.
Discuss the long-term and short-term implications of purchasing power parity on nominal exchange rates.
What does it mean for the real exchange rate (RER) to approximate 1 under Absolute PPP?
What does it mean for the real exchange rate (RER) to approximate 1 under Absolute PPP?
How does the inflation differential between domestic and foreign economies affect the appreciation or depreciation of the domestic currency according to Relative PPP?
How does the inflation differential between domestic and foreign economies affect the appreciation or depreciation of the domestic currency according to Relative PPP?
Describe the behavior of the real exchange rate under a fixed nominal exchange rate regime.
Describe the behavior of the real exchange rate under a fixed nominal exchange rate regime.
In what scenarios does nominal exchange rate volatility primarily affect the real exchange rate?
In what scenarios does nominal exchange rate volatility primarily affect the real exchange rate?
What are the implications of domestic currency depreciation in terms of foreign purchasing power?
What are the implications of domestic currency depreciation in terms of foreign purchasing power?
What factors can increase the demand for domestic currency in the foreign exchange market?
What factors can increase the demand for domestic currency in the foreign exchange market?
How does a flight to safety during market turbulence affect the supply of domestic currency?
How does a flight to safety during market turbulence affect the supply of domestic currency?
What role does changing tastes play in influencing the demand for foreign goods?
What role does changing tastes play in influencing the demand for foreign goods?
Explain how higher national GDP influences exchange rates.
Explain how higher national GDP influences exchange rates.
What is the impact of increased real returns abroad on foreign currency demand?
What is the impact of increased real returns abroad on foreign currency demand?
How does the concept of purchasing power parity relate to nominal exchange rates?
How does the concept of purchasing power parity relate to nominal exchange rates?
Define the equilibrium nominal exchange rate.
Define the equilibrium nominal exchange rate.
What can lead to a shift in the supply of AUD in the forex market?
What can lead to a shift in the supply of AUD in the forex market?
Makes foreign goods cheaper and domestic goods more expensive, increases imports and/or decreases exports, decreasing net ______
Makes foreign goods cheaper and domestic goods more expensive, increases imports and/or decreases exports, decreasing net ______
A key idea in the Law of One Price is that tradeable goods should sell for the same price everywhere, when prices are denominated in a common ______
A key idea in the Law of One Price is that tradeable goods should sell for the same price everywhere, when prices are denominated in a common ______
RER can change due to changes in ______ exchange rate E and/or changes in relative price levels P/P f
RER can change due to changes in ______ exchange rate E and/or changes in relative price levels P/P f
A floating exchange rate is ______ determined relative price of currency based on supply and demand.
A floating exchange rate is ______ determined relative price of currency based on supply and demand.
Crisis occurs when the current exchange rate regime is not ______
Crisis occurs when the current exchange rate regime is not ______
A currency union is a strong form of ______ standard.
A currency union is a strong form of ______ standard.
An increase in the nominal exchange rate indicates a depreciation of the ______ currency.
An increase in the nominal exchange rate indicates a depreciation of the ______ currency.
The real exchange rate can adjust even if the nominal exchange rate is ______.
The real exchange rate can adjust even if the nominal exchange rate is ______.
Absolute PPP hypothesis assumes that the law of one price holds for the whole consumption ______.
Absolute PPP hypothesis assumes that the law of one price holds for the whole consumption ______.
If Relative PPP holds, domestic currency appreciates when foreign inflation is greater than domestic ______.
If Relative PPP holds, domestic currency appreciates when foreign inflation is greater than domestic ______.
In the long run, the nominal exchange rate mostly reflects price level differences and the real exchange rate is approximately ______.
In the long run, the nominal exchange rate mostly reflects price level differences and the real exchange rate is approximately ______.
Relative PPP requires that the change in real exchange rate equals the inflation differential, represented as gE = πf − ______.
Relative PPP requires that the change in real exchange rate equals the inflation differential, represented as gE = πf − ______.
Domestic currency depreciates if foreign inflation is less than domestic ______.
Domestic currency depreciates if foreign inflation is less than domestic ______.
Short-run changes in the real exchange rate are usually due to variations in the nominal exchange rate ______.
Short-run changes in the real exchange rate are usually due to variations in the nominal exchange rate ______.
With a floating nominal exchange rate, there is a close co-movement of nominal and real exchange rates, especially in countries with low and stable ______.
With a floating nominal exchange rate, there is a close co-movement of nominal and real exchange rates, especially in countries with low and stable ______.
Purchasing Power Parity provides a guideline for long-run exchange rate dynamics when a country is experiencing high ______.
Purchasing Power Parity provides a guideline for long-run exchange rate dynamics when a country is experiencing high ______.
The ______ exchange rate is the relative price of one currency in terms of another.
The ______ exchange rate is the relative price of one currency in terms of another.
When RER < 1, foreign goods seem ______ in real terms.
When RER < 1, foreign goods seem ______ in real terms.
An increase in the nominal exchange rate E indicates an appreciation of the ______ against the USD.
An increase in the nominal exchange rate E indicates an appreciation of the ______ against the USD.
Countries with ______ exchange rates find their monetary policy less effective at stabilizing domestic demand.
Countries with ______ exchange rates find their monetary policy less effective at stabilizing domestic demand.
The ______ exchange rate reflects the relative price of a consumption basket in terms of another currency.
The ______ exchange rate reflects the relative price of a consumption basket in terms of another currency.
Changes in GDP can occur through fluctuations in the quantities of exports and ______.
Changes in GDP can occur through fluctuations in the quantities of exports and ______.
Purchasing power parity connects expected changes in exchange rates with ______ rates across countries.
Purchasing power parity connects expected changes in exchange rates with ______ rates across countries.
In an indirect quote, the foreign currency is expressed as ______ currency per unit of domestic currency.
In an indirect quote, the foreign currency is expressed as ______ currency per unit of domestic currency.
Currencies are traded in foreign ______ markets.
Currencies are traded in foreign ______ markets.
Domestic households and firms supply domestic currency to buy foreign ______, services, and assets.
Domestic households and firms supply domestic currency to buy foreign ______, services, and assets.
An increased demand for foreign goods can arise from changing ______ and higher national GDP.
An increased demand for foreign goods can arise from changing ______ and higher national GDP.
Higher real returns abroad can lead to increased demand for foreign ______.
Higher real returns abroad can lead to increased demand for foreign ______.
The equilibrium nominal exchange rate occurs when supply equals ______.
The equilibrium nominal exchange rate occurs when supply equals ______.
Increased demand for domestic goods can be driven by changing tastes and higher national ______.
Increased demand for domestic goods can be driven by changing tastes and higher national ______.
A flight to safety in times of market turbulence often leads to increased demand for domestic ______.
A flight to safety in times of market turbulence often leads to increased demand for domestic ______.
Exchange rate determination using supply and demand models helps explain the concepts of ______ and depreciation.
Exchange rate determination using supply and demand models helps explain the concepts of ______ and depreciation.
Study Notes
Nominal vs. Real Exchange Rates
- The nominal exchange rate is the relative price of one currency in terms of another
- There are two conventions for a bilateral nominal exchange rate:
- Direct Quote: Domestic currency per unit foreign currency
- Indirect Quote: Foreign currency per unit domestic currency
- There are two conventions for a bilateral nominal exchange rate:
- The real exchange rate is the relative price of one consumption basket in terms of another
- Real exchange rate (RER) can be calculated by: RER = (P * E) / Pf, where P is the domestic price level, Pf is the foreign price level in foreign currency and E is the nominal exchange rate.
- When RER > 1, foreign goods seem cheap in real terms
- When RER < 1, foreign goods seem expensive in real terms
- Increase in RER (appreciation): Makes foreign goods cheaper and domestic goods more expensive, decreasing net exports.
- Decrease in RER (depreciation): Makes foreign goods more expensive and domestic goods cheaper, increasing net exports.
Exchange Rate Regimes
- Exchange rate regimes are a macroeconomic policy choice
- Nominal exchange rates can be either floating or fixed.
- Floating: market-determined relative price of currency where currency values are determined by the supply and demand for currencies.
- Fixed: policy-makers set the value of the currency.
Purchasing Power Parity (PPP)
- The law of one price states that tradeable goods should sell for the same price everywhere, once prices are denominated in a common currency.
- Absolute Purchasing Power Parity (PPP) assumes that the law of one price holds for the whole consumption basket, i.e., RER = 1. It implies that the real purchasing power is the same in both countries.
- Relative PPP is the idea that the real exchange rate is constant in the long-run and implies that changes in nominal exchange rate gE equal to the inflation differential πf − π.
- If Relative PPP holds:
- Domestic currency appreciates (gE > 0) if foreign inflation is greater than domestic inflation (πf > π)
- Domestic currency depreciates (gE < 0) if foreign inflation is less than domestic inflation (πf < π)
- If Relative PPP holds:
- Relative PPP does not imply Absolute PPP
- In the long run:
- Nominal exchange rate E mostly reflects price level differences P/Pf and the RER ≈ constant
- PPP provides a good guide to assessing long-run exchange rate dynamics, especially for countries experiencing high inflation.
- In the short-run:
- Changes in the real exchange rate are mostly due to changes in the nominal exchange rate E.
- PPP provides a poor guide to short-run exchange rate dynamics, especially for countries with low and stable inflation rates.
Supply & Demand for Foreign Exchange
- The supply of domestic currency is driven by:
- Domestic households and firms that want foreign currency to buy foreign goods, services and assets.
- The demand for domestic currency is driven by:
- Foreign households and firms that want domestic currency to buy domestic goods, services and assets.
- The equilibrium nominal exchange rate occurs when the supply equals the demand.
- Factors that shift the supply of domestic currency:
- Increased demand for foreign goods and services
- Increased demand for foreign assets
- Factors that shift the demand for domestic currency:
- Increased demand for domestic goods and services
- Increased demand for domestic assets
Nominal vs. Real Exchange Rates
- The nominal exchange rate is the price of one currency in terms of another.
- Direct quote uses domestic currency per unit of foreign currency.
- Indirect quote uses foreign currency per unit of domestic currency.
- Appreciation of a currency occurs when the value of the currency increases relative to another currency.
- Depreciation of a currency occurs when the value of the currency decreases relative to another currency.
Real Exchange Rate
- The real exchange rate is the relative price of one consumption basket in terms of another.
- Calculated by dividing the domestic price level by the foreign price level converted into domestic currency.
- When the real exchange rate is greater than 1, foreign goods appear cheaper in real terms.
- When the real exchange rate is less than 1, foreign goods appear more expensive in real terms.
- Changes in the real exchange rate can be due to changes in the nominal exchange rate or changes in relative price levels.
Exchange Rate Regimes
- Exchange rate regimes are macroeconomic policy choices.
- Nominal exchange rates can be floating, fixed, or a combination of both.
- Floating exchange rates are determined by market supply and demand.
- Fixed exchange rates are established by policymakers.
- A currency union is a fixed exchange rate system with no independent monetary policy.
Purchasing Power Parity (PPP)
- PPP is a theory that states that the price of a good should be the same in all countries after accounting for exchange rates.
- Absolute PPP states that the price level of a country's consumption basket is the same in all countries after accounting for exchange rates.
- Relative PPP states that changes in the nominal exchange rate are equal to the inflation differential between two countries.
Nominal Exchange Rates in the Short Run
- Supply and demand for foreign exchange determines the nominal exchange rate in the short run.
- Supply of domestic currency comes from domestic residents who want to buy foreign goods, services, and assets.
- Demand for domestic currency comes from foreign residents who want to buy domestic goods, services, and assets.
- Changes in demand for foreign goods and services, demand for foreign assets, demand for domestic goods and services, and demand for domestic assets can shift the supply and demand curves for foreign exchange.
Nominal vs. Real Exchange Rates
- The nominal exchange rate is the price of one currency in terms of another.
- An increase in the nominal exchange rate corresponds to an appreciation of the first currency against the second.
- The real exchange rate is the relative price of a basket of goods in one country compared to another.
- It is calculated by dividing the domestic price level by the foreign price level adjusted for the nominal exchange rate.
- A real appreciation makes foreign goods cheaper and domestic goods more expensive.
- A real depreciation makes foreign goods more expensive and domestic goods cheaper.
Exchange Rate Regimes
- A country can choose to have a floating or fixed exchange rate regime.
- In a floating exchange rate regime, the exchange rate is determined by the supply and demand of currencies in the market.
- In a fixed exchange rate regime, the government sets the exchange rate, and promises to buy or sell enough of its currency to maintain it.
- A currency union is an example of a strong form of currency standard, where several countries share a single currency.
Purchasing Power Parity (PPP)
- PPP is the theory that the exchange rate between two currencies should equal the ratio of the price levels of a basket of goods in the two countries.
- Absolute PPP states that the price levels of a basket of goods should be the same in both countries when converted to a common currency.
- Relative PPP states that changes in the nominal exchange rate will be equal to the difference in inflation rates between the two countries.
- PPP is a good guide to long-run exchange rate dynamics, but not to short-run dynamics, particularly for countries with low and stable inflation rates.
Nominal Exchange Rates in the Short Run
- In the short run, the nominal exchange rate is determined by supply and demand for currencies in the foreign exchange market.
- Factors affecting the supply of domestic currency include the demand for foreign goods and services and assets.
- Factors affecting the demand for domestic currency include the demand for domestic goods and services and assets.
- An increase in the supply of domestic currency will cause the currency to depreciate, while an increase in demand will cause it to appreciate.
Nominal vs. Real Exchange Rates
- The nominal exchange rate is the price of one currency in terms of another.
- It is commonly expressed as an indirect quote: the amount of foreign currency needed to purchase one unit of the domestic currency.
- The real exchange rate is the relative price of a consumption basket in one country compared to another.
- It takes into account the price levels of both countries.
- A higher real exchange rate implies that foreign goods are relatively cheaper in real terms.
Exchange Rate Regimes
- A fixed exchange rate regime involves the government fixing the price of its currency in terms of another currency or commodity.
- A floating exchange rate regime allows the exchange rate to be determined by market forces of supply and demand.
- Australia has a floating exchange rate regime since 1983.
Purchasing Power Parity (PPP)
- The law of one price states that identical goods should trade for the same price in different countries when prices are expressed in a common currency.
- Absolute PPP implies that the real exchange rate is always equal to 1.
- Relative PPP implies that the percentage change in the nominal exchange rate equals the inflation differential between the two countries.
- PPP is more relevant in the long run, especially for countries with high inflation levels.
Nominal Exchange Rates in the Short-Run: Supply & Demand
- The exchange rate is determined by the supply and demand for the currency in the foreign exchange market.
- The supply of a currency comes from domestic residents seeking foreign currency to buy foreign goods, services, or assets.
- The demand for a currency comes from foreigners seeking domestic currency to buy domestic goods, services, or assets.
- Changes in tastes, national GDP, real returns abroad, and flight to safety can shift the supply and demand curves for a currency, leading to changes in the exchange rate.
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Test your understanding of nominal and real exchange rates. This quiz covers definitions, calculations, and the implications of changes in exchange rates on trade. Understanding these concepts is crucial for economics students and professionals.
