Real Exchange Rate & Purchasing Power Parity

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Questions and Answers

According to the definition provided, how is the real exchange rate ($q_{D/F}$) calculated?

$q_{D/F} = \frac{E_{D/F}P_F}{P_D}$ where $E_{D/F}$ is the nominal exchange rate, $P_F$ is the price of the foreign consumption basket, and $P_D$ is the price of the domestic consumption basket.

Explain how an increase in the money supply affects the real exchange rate in the long run. Why does this occur?

An increase in the money supply has no effect on the real exchange rate in the long run. This is because the increase in money supply leads to proportional increases in domestic prices and the nominal exchange rate, offsetting each other in the real exchange rate calculation.

List the two main factors that determine the real exchange rate.

The real exchange rate is determined by the relative supply of foreign and domestic goods in the world economy, and the relative demand for foreign and domestic goods in the world economy.

Explain how an increase in the relative supply of domestic goods affects the real exchange rate ($q_{D/F}$).

An increase in the relative supply of domestic goods leads to an increase in $q_{D/F}$, meaning a real depreciation of the domestic currency. Signup and view all the answers

Explain the relationship between PPP and the real exchange rate. When is the real exchange rate equal to 1 according to PPP?

According to PPP, the real exchange rate is always equal to 1. This implies that one domestic consumption basket is worth exactly one foreign consumption basket. Signup and view all the answers

Why is the real exchange rate theory considered a generalization or extension of Purchasing Power Parity (PPP)?

The real exchange rate theory is a generalization of PPP because it relaxes the assumption that the relative price of domestic and foreign consumption baskets is constant and equal to 1, allowing it to take on any value. Signup and view all the answers

List three simplifying assumptions made by the PPP model that the real exchange rate theory relaxes.

The PPP model assumes that all goods are traded, consumption bundles are the same across countries, and shipping is costless. The real exchange rate theory relaxes these assumptions. Signup and view all the answers

Explain how an increase in the relative demand for domestic goods impacts the real exchange rate ($q_{D/F}$).

An increase in the relative demand for domestic goods leads to a decrease in $q_{D/F}$, signifying a real appreciation of the domestic currency. Signup and view all the answers

According to the information provided, what does it mean if the real exchange rate ($q_{D/F}$) is not equal to 1?

If the real exchange rate ($q_{D/F}$) is not equal to 1, it indicates that the Purchasing Power Parity (PPP) equation is not satisfied. Signup and view all the answers

What is the effect of a one-time increase in the domestic money supply on the nominal exchange rate ($E_{D/F}$) according to the RER model presented?

A one-time increase in the domestic money supply leads to a proportional increase in the nominal exchange rate ($E_{D/F}$). Signup and view all the answers

If a country experiences an increase in the growth rate of its money supply ($π^e_D$), how does this immediately impact the nominal interest rate ($R_D$)?

The nominal interest rate ($R_D$) jumps upwards immediately after the announcement of an increase in the growth rate of money supply. Signup and view all the answers

Following an increase in the money growth rate, what happens to the rate at which the domestic currency depreciates?

After the announcement, the rate at which the domestic currency depreciates increases to reflect the higher growth rate of money. Signup and view all the answers

Explain real interest rate parity and how it relates to the expected depreciation of domestic currency.

Real interest rate parity states that differences in expected real interest rates between two countries are equal to the expected real depreciation of the domestic currency. Signup and view all the answers

How does an increase in domestic output ($Y_D$) affect the domestic price level ($P_D$), assuming the money supply and interest rate are unchanged?

An increase in domestic output ($Y_D$) leads to a decrease in the domestic price level ($P_D$). Signup and view all the answers

Explain the impact of long-run domestic output being determined solely by the endowment of factors in the domestic economy.

The long-run domestic output being determined solely by the endowment of factors means it is independent of the real exchange rate. Signup and view all the answers

Explain the conditions for a country to be in equilibrium according to the Real Exchange Rate (RER) model.

For a country to be in equilibrium, the money market, foreign exchange rate market, and output market must all be in equilibrium. Signup and view all the answers

Differentiate between nominal and real values in the context of economics, particularly in reference to exchange rates.

Nominal values are measured in units of currency, while real values are measured in units of a consumption bundle. Signup and view all the answers

Describe how the relative demand curve is sloped and what it measures in the context of real exchange rate determination.

The relative demand curve is upward sloping and measures the relative demand for domestic and foreign goods. It slopes upward because, as domestic goods become cheaper, the demand for them increases. Signup and view all the answers

Which markets are included in the Real Exchange Rate (RER) Model?

The Real Exchange Rate (RER) Model is based on three markets: money market, foreign exchange rate market, and output market. Signup and view all the answers

Consider a scenario where there's an improvement in the educational system that leads to increased productivity. What ambiguities arise in the overall effect on the nominal exchange rate?

The nominal exchange rate's overall direction is unclear. The output market's push could lead to downward pressure on the nominal exchange rate, whereas equilibrium adjustments could push it upward. The overall direction will depend on which effect is greater. Signup and view all the answers

Flashcards

Real Exchange Rate

The price of a foreign consumption basket expressed in domestic currency, relative to the price of a domestic consumption basket.

E(D/F)

The nominal exchange rate between domestic and foreign currency.