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Unformatted text preview: Macroeconomic policy Class Notes Money and Exchange rates Revised: December 13, 2011 Latest version available at www.fperri.net/teaching/macropolicyf11.htm So far we have learned that monetary policy can affect the interest rate and output in the short run and that in the long run it does not affect real interest rates nor output but it affects prices (long run money neutrality). Now we will focus on the effects of monetary policy on the international variables focusing in particular on exchange rates. Real and Nominal Exchange Rates We usually refer to two types of exchange rates: real and nominal. The nominal exchange rate is just the price of a currency (i.e. of the piece of paper issued by the central bank of a given country) in terms of another. In other words the exchange rate tells me how many units of foreign currency can I get with a unit of my currency. When we say that the exchange rate of the Canadian dollars relative to US dollar is 1.5 we mean we get 1 . 5 Canadian dollars with 1 US dollar. We say that dollar depreciates when we get less foreign currency with a dollar and appreciates when we get more foreign currency with a dollar. The real exchange rate on the other hand is just the relative price (expressed in the same currency) of a particular good or basket of goods in two countries. This tells how many foreign goods can we get with a given American good. An example of that is how many Prada suits can I buy in Italy with the value of the same suit made in US by Calvin Klein. A possible way of measuring this is to sell my CK suit, exchange my dollar revenue in euros and then compare the sum with the price of the Prada suit. For example if the price of a CK suit in US is 1000$ and the exchange rate between dollar and euros is 0.8 I get 800 euros from selling the CK suit. If the price of a Prada suit in Italy is 400 Euros this means I can buy 2 Prada suits in Italy with the value 1 CK suit in US, or that the real exchange rate for suits is 2. In this Exchange rates 2 example American suits are more expensive than Italian suits so Italian suit makers are going to be more competitive on the world markets. So the real exchange rate is also a measure of competitiveness. Most often instead of focusing on a single good we focus on the price of an aggregate of goods (like the basket that compose the CPI) so the real exchange rate is computed as rx = P * e P * where P is the domestic general price level, e is the nominal exchange rate and P * is the foreign price level. Consider again the case of US versus Europe. If the US real exchange rate goes up is either because P (American prices) goes up, or because e goes up (the dollar appreciates) or because P * goes down (the euro prices go down) In all these cases we observe an increase in competitiveness of European goods relative to US goods. Often also instead of just the real (or nominal) exchange rate with one country statistics report the value of the dollar against a group of currencies or...
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