week5 - Prices and Exchange Rates in the Long-Run Viktoria...

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Prices and Exchange Rates in the Long-Run Viktoria Hnatkovska week 5 1
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Overview In 1950 the yen traded at 360 yen/$. In the spring of 1999, the yen traded at 120 yen. Objective : Understand what determines such dramatic long-term movements in exchange rates? What models can predict how exchange rates behave? In last chapter we developed a short run model and a long run model that used movements in the money supply. In this chapter, we develop 2 more models, building on the long run approach from last chapter. Long run means a su¢ cient amount of time for prices of all goods and services to adjust to market conditions so that their markets and the money market are in equilibrium. in the long run models. Long-run determinants of exchange rates: Expectations of future exchange rate: Monetary changes and long-run price levels PPP + monetary approach Beyond PPP and monetary approach 2
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Law of One Price The law of one price simply says that the same good in di/erent competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important. Why? Suppose the price of pizza at one restaurant is $20, while the price of the same pizza at an identical restaurant across the street is $40. What do you predict to happen? Many people would buy the $20 pizza, few would buy the $40 one. Due to the price di/erence, entrepreneurs would have an incentive to buy pizza at the cheap Due to strong demand and decreased supply, the price of the $20 pizza would tend to increase. Due to weak demand and increased supply, the price of the $40 pizza would tend to decrease. Sellers would have an incentive to adjust their prices until one price is achieved across markets (across restaurants). 3
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Law of One Price Consider a pizza restaurant in Seattle and one across the border in Vancouver. The law of one price says that the price of the same pizza (using a common currency to measure the price) in the two cities must be the same if markets are competitive transportation costs and barriers between markets are not important. P pizza US = E US $ =CAN $ ± P pizza CAN Purchasing power parity is the application of the law of one price across countries for P US = E US $ =CAN $ ± P CAN ; where P US = level of average prices in the US P CAN = level of average prices in Canada E US $ =CAN $ = US dollar/Canadian dollar exchange rate 4
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Purchasing power parity (PPP) The oldest theory of exchange rate determination put forth by the 19th century economists including David Ricardo. PPP asserts that the same basket of goods must cost the same in di/erent countries, once
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week5 - Prices and Exchange Rates in the Long-Run Viktoria...

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