Ch11_Exchange Rates Long Run.docx

# Ch11_Exchange Rates Long Run.docx - Chapter 11 Exchange...

• 12

This preview shows pages 1–4. Sign up to view the full content.

Chapter 11: Exchange rates I: the Monetary Approach in the Long Run Background: In this chapter, we first develop the purchasing power parity (PPP) theory that connects exchange rates to price levels. We then use the monetary theory to explain what determines price levels and interest rates in the long run. Section 1: Linking exchange rates to prices A major reason for acquiring different currencies is to __________ and ___________ in different countries. So a natural start to think about exchange rates is to look at prices of the same good around the world. ________________________________ states that in the absence of __________________, and under the conditions of _____________ and ________________, identical goods sold in different locations must sell for the same prices when the prices are expressed in a common currency. Let P EUR g denote the _______ price of good g sold in the EU, P US g the __________ price of good g sold in the US, and E \$ / the spot exchange rate of _________ against _______. Mathematically, LOOP means P US g = P EUR g E \$ / That is, if we use dollar as the _________________, the _______ prices of the same goods g at two locations should be equal. Otherwise there are ____________ opportunities, and it will ensure that LOOP holds eventually. Example: A textbook sells for €100 in Belgium and E \$ / = 1.2 (i.e., the exchange rate is _______ per _______). The same textbook sells for \$150 in the US. In this case, the textbook is cheaper in ____________. 1

This preview has intentionally blurred sections. Sign up to view the full version.

The LOOP _____________ hold. Given this exchange rate, the textbook should sell for \$____________________ in the US if LOOP holds. Define the ________________ of good g as q US / EUR g = P EUR g E \$ / P US g q US / EUR g measures how many units of the _____________ are equivalent to one unit of the same good in ________________. LOOP implies that ¿ ¿ ¿ q US / EUR g = ¿ ¿ . There is _______________ opportunity if q US / EUR g ________________________. Exercise: Show how arbitrage works when q US / EUR g > 1 . Step 1: q US / EUR g > 1 implies ¿ ¿ ¿ P EUR g E ¿ P US g , i.e., g is more costly in (EU or US) Step 2: people will buy g in (EU or US) and sell it in (EU or US) Step 3: P EUR g will go (up or down); P US g will go (up or down) Step 4: q US / EUR g will converge to __________. LOOP offers a way to determine the exchange rates. If LOOP holds, then P US g = P EUR g E \$ / . Solve for 2
E \$ / = ¿ That is, the exchange rate equals the __________________ of good g . Example: If a pair of jeans is priced at \$50 in the US and it is priced at €40 in the EU, then LOOP implies that ¿ ¿ ¿ ¿ ¿ ¿ ¿ ¿ E \$ / = ¿ ¿ If we expand our focus from the price of ________________ to prices of ___________________________ in two countries, LOOP evolves into ____________________________________. PPP means that the same

This preview has intentionally blurred sections. Sign up to view the full version.

This is the end of the preview. Sign up to access the rest of the document.
• Spring '08
• Dunlevy

{[ snackBarMessage ]}

### What students are saying

• As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

Kiran Temple University Fox School of Business ‘17, Course Hero Intern

• I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

Dana University of Pennsylvania ‘17, Course Hero Intern

• The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

Jill Tulane University ‘16, Course Hero Intern