365 Topic3 - ECO365 Topic 3 Exchange Rates and The Long Run...

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Exchange Rates and The Long Run ECO365 Topic 3
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Overview In the previous topic, we learned how the spot exchange rate is determined using the uncovered interest parity condition. We took as given the following: Expected future exchange rate Interest rates in the two countries In this topic, we focus on the determinants of the expected future exchange rate. 2 ECO365
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Overview 1. PPP and the Goods market equilibrium 2. A simple model of money market equilibrium 3. Implications and evidence of the simple model 4. A general model with money, prices and interest rate 3 ECO365
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Law of One Price Consider a single good, g , in 2 different markets Europe and the U.S. The relative price of good g is 4 ECO365
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Law of One Price Definition : The Law of One Price (LOOP) states that identical goods sold in different countries should have the same price, when the prices are expressed in the same currency. If the LOOP holds, then Key assumptions : No transaction costs No barriers to trade Competitive markets Flexible prices 5 ECO365
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Purchasing Power Parity PPP is the macroeconomic counterpart to the LOOP. The price level in a country is the weighted average of the prices of all goods in a reference basket. The relative price of the basket of good is 6 ECO365
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Purchasing Power Parity Definition : The Purchasing Power Parity (PPP) states that the exchange rate is equal to the ratio of the price level of the home country (US) and the foreign country (Europe). If the PPP holds, then E $/ = P US /P E PPP theory can be used to predict exchange rate movements. 7 ECO365
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Purchasing Power Parity Relation with the Law of One Price The PPP applies to general price levels while the LOOP is about individual goods. If the LOOP holds for all goods, the PPP usually holds. The PPP can hold despite deviations from the LOOP. 8 ECO365
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Purchasing Power Parity The relative price level ratio q is an important variable in international macro. It is called the real exchange rate. Nominal exchange rate E is the ratio at which currencies trade, whereas Real exchange rate q is the ratio at which goods baskets trade. If the real exchange rate rises, we have a real depreciation - more home goods needed in exchange for foreign goods. If the real exchange rate is above one (PPP does not hold) foreign (European) goods are relatively expensive. foreign currency (euro) is said to be overvalued. 9 ECO365
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Absolute PPP (or simply PPP) is a statement about price levels and exchange rates. If this is true in levels of exchange rates and prices, then it is also true in rates of change . 10
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This note was uploaded on 02/24/2012 for the course ECO 365 taught by Professor Jordimondria during the Spring '08 term at University of Toronto- Toronto.

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365 Topic3 - ECO365 Topic 3 Exchange Rates and The Long Run...

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