Chapter 19

Chapter 19 - 6/23/2011 19.1 Introduction Chapter 19...

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6/23/2011 1 Chapter 19 Exchange Rates and Internationa and International Finance Charles I. Jones 19.1 Introduction • In this chapter, we learn: – how nominal and real exchange rates are determined, in both the short run and the long run – the key role played by the law of one price in determining exchange rates – how to incorporate exchange rates and a richer theory of the open economy into our short-run model • about international financial systems: – the gold standard – the Bretton Woods system – the current system of floating exchange rates • the lessons from recent financial crises in Mexico, Asia, and Argentina. • international trade of goods and services exceeds 20 percent of GDP in most countries 19.2 Exchange Rates in the Long Run The Nominal Exchange Rate • The nominal exchange rate: – is the rate that a currency trades for another. – simply the price of the dollar. • A depreciation of the dollar: – decline in the price of the dollar – a decline in the exchange rate An appreciation of the dollar • An appreciation of the dollar: – the dollar rises in value – the exchange rate rises.
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6/23/2011 2 The Law of One Price • The law of one price: – says in the long run goods must sell for the same price in all countries – If prices were different, the opportunity for arbitrage exists – implies that the exchange rate times the domestic price must equal the foreign price • In other words: Exchange Rate Price of goods in US World Price • Units on the exchange rate are foreign currency per domestic currency. • Law may not hold exactly – Different taxes, tariffs, and transportation costs • The quantity theory of money – pins down the price levels in the long run • The law of one price – pins down the exchange rate • The nominal exchange rate: Nominal Exchange Rate Long run price ratio • In the long run: – the exchange rate is determined by the amount of money in one country relative to another • If the dollar depreciates: If the dollar depreciates: – the price level in the foreign country must rise more slowly than in the United States – inflation was higher in the domestic country than it was in the foreign country
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6/23/2011 3 Case Study: The Big Mac Index • The law of one price fails to hold for Big Macs because: – If a currency is undervalued • the price will appear lower hil if i l d – while if a currency is overvalued • the price will appear higher – Real estate and labor are cheap in countries like China – The law of one price applies only to goods that can easily be traded. The Real Exchange Rate • The real exchange rate (RER) – computed by adjusting the nominal exchange rate by the relative price levels • The units of the RER are foreign goods per domestic (US) goods: • Equal to the number of foreign goods required to purchase a single unit of the same United States good.
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Chapter 19 - 6/23/2011 19.1 Introduction Chapter 19...

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