MIT14_02F09_lec20_22

MIT14_02F09_lec20_22 - TOPIC TOPIC 8 International...

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TOPIC 8 International Economics

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Goals of Topic 8 What is the exchange rate? NX back!! What is the link between the exchange rate and net exports? What is the trade deficit? How do different shocks affect the exchange rate and net exports? ow do different policies affect the trade deficit? How do different policies affect the trade deficit? Has the current recession been transmitted abroad? 2
Nominal exchange rates •T h e nominal exchange rate is the rate at which two currencies are exchanged! Example: the nominal exchange rate between the US dollars and the Japanese Yen is 110 yen per dollar It means that 1 dollar can buy 110 yen in the foreign exchange market (the market for international currencies) More technically: The nominal exchange rate, e nom , between two currencies is the number of units of foreign currency that can be purchased with 1 unit of domestic currencies . 3

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Real Exchange Rates If you know that e nom = 110 yen, do you know if it is cheaper to leave in Japan or in the US? NO! You need more information about prices … •T h e real exchange rate is the price of domestic goods relative to foreign goods More technically The real exchange rate, e, is the number of foreign goods that can be obtained in exchange for 1 unit of the domestic good: 4 e = (e nom * P) / P f
Purchasing Power Parity (PPP) How are nominal and real exchange rates related? •I m a gine two countries produce the same goods and goods are freely traded. Then trade is possible only if real exchange rates are equal to 1! PPP = the price of the domestic good must equal the price of the foreign good, in terms of the domestic currency: P = P f / e nom e nom = P f / P 5 Empirical evidence: PPP tends to hold in the long run, but not in the short run. Why? Different goods, non-traded goods, trade tariffs,…

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Why does the real exchange rate matters? Real exchange rate represents the rate at which domestic goods (and services) can be traded for those produced abroad (terms of trade) Why an increase in the real exchange matters? 1. people are able to obtain more foreign goods in exchange for a given amount of domestic goods 2. Net export is going to be lower (substitution effect!) •E x ample: US cars costs twice as much as a Japanese cars. Then Americans a p e: US ca s cos s w ce as uc as a Japa ese ca s. e e ca s will demand more Japanese cars, so import will increase. Japanese will demand less US cars, so export decrease. It follows that NX decrease! 6 Real exchange rate is the relative price of a country’s good. If it increases, people will switch towards other countries’ goods.
Real exchange rate decreases: J curve NX time Japanese cars are more expensive than US ones. Substitution effect can take time to kick in … On Impact: Americans import the same amount of Japanese cars, but they are more 7 expensive. Then, the nominal value of import increases and NX decreases Later: American stop importing Japanese cars and NX increases.

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This note was uploaded on 11/18/2011 for the course ECON 14.02 taught by Professor Veronicaguerrieri during the Fall '09 term at MIT.

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MIT14_02F09_lec20_22 - TOPIC TOPIC 8 International...

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