ch11 (3) - Consider a single good, g, in 2 different...

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Consider a single good, g , in 2 different markets. If the real exchange rate is below one (by x %) foreign (European) goods are relatively cheap foreign currency (euro) is said to be undervalued (by x %). why? euros are x% cheaper than they would have to be to satisfy PPP. We can now see that PPP supplies a reference level for what the exchange rate. Rearrange the PPP equation: PPP implies that the exchange rate at which two currencies trade is equal to the relative price levels of the two countries. PPP theory can be used to predict exchange rate movements – these simply reflect relative prices, so all we need to do is predict prices. The absolute PPP equation: If this is true in levels of exchange rates and prices, then it is also true in rates of change . The rate of change in the exchange rate is the rate of depreciation in the home currency (U.S. $): The rate of change in relative prices (P US /P E ) is the home-foreign inflation
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This note was uploaded on 03/02/2012 for the course EC 340 taught by Professor Ballie during the Spring '10 term at Michigan State University.

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ch11 (3) - Consider a single good, g, in 2 different...

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