Ch11_Exchange Rates Long Run.docx

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

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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
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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
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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
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