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lecture6new - Summary We have 2 theories of exchange rates...

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Summary We have 2 theories of exchange rates Asset approach – P fixed, R adjusts – Built on UIP and money market – Useful in the short run, and for shocks to M – Results: short-run; long-run overshooting (with M neutrality)
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Summary Law of one price – Identical goods sold in different countries sell for the same prices expressed in terms of a common currency. P US i = E $/€ P E i where P US i is price of a particular good in US, P E i is price of a particular good in Europe . Absolute PPP says that the relation is true, not just for price of a single good, but for the overall price level of an entire economy. P US = E $/€ P E where P US i is price index in US, is P E price index in Europe. E.g., the CPI. Relative PPP : express variables in percent changes, and inflation is written πt = (Pt – Pt–1)/ Pt–1. (E $/€,t – E $/€,t–1 )/ E $/€,t–1 = π US,t – π E,t
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Monetary approach E $/€ = [Ms US / L(R $ ,Y US )]/ [Ms E / L(R ,Y E )] – R fixed and P adjusts – Built on PPP and money market – Useful in long run, and for shocks to M and its growth rate – Results: supports asset approach assumptions about the long run; Ongoing inflation, interest parity and PPP What happens if we stop assuming that M is a constant but policymakers target the growth rate of M as the policy variable? Fisher effect: R $ – R = π e US – π e E - when PPP holds, nominal inflation rate differentials must exactly
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