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Questions and Answers
What does an increase in the nominal exchange rate (E) represent when quoted as USD per AUD?
What does an increase in the nominal exchange rate (E) represent when quoted as USD per AUD?
- Decrease in the import demand from Australia
- Depreciation of the AUD against the USD
- Appreciation of the AUD against the USD (correct)
- Increase in the value of USD in the market
What is the primary effect of fixed exchange rates on monetary policy?
What is the primary effect of fixed exchange rates on monetary policy?
- Limits the ability to respond to economic fluctuations (correct)
- Makes monetary policy irrelevant for international trade
- Increases effectiveness at stabilizing domestic demand
- Encourages higher interest rates in domestic markets
How is the real exchange rate (RER) calculated?
How is the real exchange rate (RER) calculated?
- Using only domestic price levels and foreign price levels
- By comparing nominal exchange rates across multiple currencies
- Through the ratio of export prices to import prices
- By adjusting nominal exchange rates by domestic and foreign price levels (correct)
When is a currency said to appreciate in real terms?
When is a currency said to appreciate in real terms?
Which of the following best describes nominal exchange rates?
Which of the following best describes nominal exchange rates?
What effect do expected changes in exchange rates have on international capital flows?
What effect do expected changes in exchange rates have on international capital flows?
What does it indicate when RER < 1?
What does it indicate when RER < 1?
Which method is typically used to quote nominal exchange rates?
Which method is typically used to quote nominal exchange rates?
What effect does a decrease in the real exchange rate (RER) have on imports and exports?
What effect does a decrease in the real exchange rate (RER) have on imports and exports?
Which of the following statements about exchange rate regimes is correct?
Which of the following statements about exchange rate regimes is correct?
What is a primary risk associated with a fixed exchange rate regime?
What is a primary risk associated with a fixed exchange rate regime?
How can the real exchange rate (RER) adjust even when the nominal exchange rate is fixed?
How can the real exchange rate (RER) adjust even when the nominal exchange rate is fixed?
What formula represents the change in real exchange rate (gRER)?
What formula represents the change in real exchange rate (gRER)?
What is the Law of One Price primarily concerned with?
What is the Law of One Price primarily concerned with?
Which statement accurately reflects the implications of currency fluctuations under a floating exchange rate?
Which statement accurately reflects the implications of currency fluctuations under a floating exchange rate?
What happens to net exports when the real exchange rate is depreciated?
What happens to net exports when the real exchange rate is depreciated?
What primarily drives the supply of domestic currency in the foreign exchange market?
What primarily drives the supply of domestic currency in the foreign exchange market?
Which factor contributes to an increased demand for domestic currency?
Which factor contributes to an increased demand for domestic currency?
What occurs at the equilibrium nominal exchange rate?
What occurs at the equilibrium nominal exchange rate?
Which of the following can shift the demand for foreign currency?
Which of the following can shift the demand for foreign currency?
What is a typical reason for higher demand for foreign goods and services?
What is a typical reason for higher demand for foreign goods and services?
What does an increased demand for foreign assets generally indicate?
What does an increased demand for foreign assets generally indicate?
What can cause a shift in the supply curve for a currency in the foreign exchange market?
What can cause a shift in the supply curve for a currency in the foreign exchange market?
What is the best explanation for the connection between nominal and real exchange rates?
What is the best explanation for the connection between nominal and real exchange rates?
What does the purchasing power parity (PPP) hypothesis suggest about real purchasing power between two countries?
What does the purchasing power parity (PPP) hypothesis suggest about real purchasing power between two countries?
In what scenario does a domestic currency appreciate according to Relative PPP?
In what scenario does a domestic currency appreciate according to Relative PPP?
Which equation represents the relationship where the nominal exchange rate remains constant under Relative PPP?
Which equation represents the relationship where the nominal exchange rate remains constant under Relative PPP?
What does Absolute PPP imply about the relationship between nominal and real exchange rates in the long run?
What does Absolute PPP imply about the relationship between nominal and real exchange rates in the long run?
If both countries experience high inflation, which statement is correct regarding Absolute and Relative PPP?
If both countries experience high inflation, which statement is correct regarding Absolute and Relative PPP?
In which condition does the real exchange rate typically show less volatility?
In which condition does the real exchange rate typically show less volatility?
How does the real exchange rate change in the short run according to the provided content?
How does the real exchange rate change in the short run according to the provided content?
What is indicated by a condition where the nominal exchange rate (E) suggests real economic stability?
What is indicated by a condition where the nominal exchange rate (E) suggests real economic stability?
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Study Notes
Nominal vs. Real Exchange Rates
- The nominal exchange rate is the price of one currency in relation to another.
- The direct quote refers to the domestic currency per unit of foreign currency.
- The indirect quote refers to the foreign currency per unit of domestic currency.
- An appreciation of a currency means its value is increasing, while depreciation signifies its value is decreasing.
- The real exchange rate takes into account the relative prices of consumption baskets in different countries.
- When the real exchange rate is greater than 1, foreign goods appear cheaper.
- A lower real exchange rate (less than 1) implies foreign goods seem expensive.
- Changes in the real exchange rate can occur due to changes in the nominal exchange rate or differences in price levels.
Exchange Rate Regimes
- Exchange rate regimes refer to the way a country chooses to manage its currency value.
- A floating exchange rate is determined by market forces (supply and demand for the currency).
- Fixed exchange rates are set by policy-makers.
- A currency union represents a strong form of a fixed exchange rate.
- A fixed exchange rate regime requires a central bank to buy or sell foreign currencies to maintain the fixed value.
Purchasing Power Parity (PPP)
- The Law of One Price states that tradeable goods should have the same price globally when converted to a common currency.
- Absolute PPP suggests that the law of one price holds for all goods in a basket.
- Relative PPP focuses on the changes in real exchange rates, implying they are driven by inflation differentials.
- PPP serves as a good indicator of long-run exchange rate dynamics, especially for countries with high inflation.
- PPP is less reliable for short-run exchange rate forecasting, particularly for low-inflation countries.
Exchange Rate Determination in the Short Run: Supply and Demand
- Currency exchange occurs in foreign exchange markets.
- The supply of a domestic currency is driven by demand for foreign goods, services, and assets by domestic residents.
- The demand for a domestic currency comes from foreigners' desire to purchase domestic goods, services, and assets.
- The equilibrium exchange rate is where the supply and demand for a currency intersect.
- Changes in trade patterns, tastes, interest rate differentials, or risk perceptions can shift the supply and demand curves for a currency.
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