LECS V & VI - EXCHANGE RATE DETERMINATION

LECS V & VI - EXCHANGE RATE DETERMINATION - DETERM...

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Click to edit Master subtitle style 11/8/10 DETERMINATION OF EXCHANGE RATES Absorption and PPP
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11/8/10 Approaches to exchange rate determination Absorption (BOP/Trade/Elasticity) approach Purchasing power parity approach Monetary approach Asset market approach
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11/8/10 Absorption approach to exchange rates The absorption approach says that exchange rates will move so as to correct any imbalance in a nation’s BOP. A deficit in the BOP/Autonomous transactions => greater domestic demand for foreign goods and services and investments than that which is being provided from domestic to foreign markets. The absorption approach to correcting a BOP dis- equilibrium says that a deficit nation will have its currency depreciated which then lowers imports and increases exports by changing their prices. Remember: By Balance of Payments we mean the surplus/deficit in autonomous transactions only.
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11/8/10 Absorption approach to exchange rates But, an increase in domestic production leads to higher domestic income leading to increases imports and thereby lowering the adjustment effect above. => Depreciation will have to be greater than if these income effects were not present. ** Moreover, if the nation is at full employment, production cannot rise and hence a depreciation will just lead to increases in the domestic price level (inflation) that will neutralize the effect of the depreciation - unless domestic consumption and/or investment fall due to contractionary fiscal and/or monetary policies. (higher taxes and/or tighter
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11/8/10 Prices and Exchange Rates.
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