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17 and 18 Money and Credit

17 and 18 Money and Credit - Chapter 17 and 18 Foreign...

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Chapter 17 and 18: Foreign Markets M&C Exchange rate – price of one currency in terms of another Nominal exchange rate – price of one currency in terms of another Real exchange rate – ratio of goods that can be ought abroad (domestically) to goods that can be bought domestically (abroad) Terms of trade – price of imported goods relative to the price of exported goods When a country’s currency appreciates (rises in value relative to other currencies), the country’s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in both countries). Conversely, when a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive The Foreign Exchange Market – market where currencies are trade and where exchange rates are determined -round the clock over the counter market – mainly banks Two times of exchange rate transactions: Spot transaction – immediate, two-day, change of bank deposits – spot exchange rate – for example, euros per dollar today Forward transaction – the exchange of bank deposits at some specified future date – forward exchange date Appreciation and depreciation of currency cause US goods to become cheaper or more expensive -when the dollar depreciates, higher prices of imported goods fuel inflation Determine exchange rates in the long run using the LAW OF ONE PRICE -the dollar price of each good should be the same throughout the world no matter who produces it Examples: Dollars and Euros p = p(f)/E p: the dollar price of the good in the US P(f): euro price of the same good in the EU E: euros for one dollar Purchasing Power Parity (PPP) : If the law of one price holds for several goods, then PPP concludes that the exchange rates are determined by changes in relative price level – rests
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on the assumption that all goods are identical in both countries and transportation costs and trade barriers are very low -PPP also does not take into account that many goods and services (which are included in a measure of a country’s price level) are not traded across borders – such as haircuts, land -Retail price of tradable goods contain non-tradable components -there ARE barriers to trade, both tarrif and non-tariff -we assume that good baskets are identical between countries, but US steel and German steel are NOT identical Good arbitrage takes time, so PPP only holds in the long run Using the theory of asset demand, the most important factor affecting the demand for domestic (dollar) assets and foreign assets is the relative expected return on the assets If relative expected return on dollar assets is greater than relative expected return on foreign assets, the demand for dollar assets is high relative to demand for euro assets Relative Price Level: In the long run, a rise in a country’s price level (relative to the foreign price level) causes its currency to depreciate, and a fall in the country’s relative
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17 and 18 Money and Credit - Chapter 17 and 18 Foreign...

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