lecture4 - ECO365 Topic 4 Exchange Rates And The Short Run...

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Exchange Rates And The Short Run ECO365 Topic 4
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Overview The monetary approach, based on PPP, works well only as a Long Run theory when prices are flexible. But prices may fail to adjust in the Short Run (when prices are “sticky”), so the monetary approach is NOT valid for Short Run analysis. In this topic, we develop the asset approach, which complements the monetary approach in providing a unified theory of exchange rates. 2 ECO365
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Overview 1. Equilibrium in the Forex market 2. Equilibrium in the Money market 3. Application of the Asset approach 4. Unified theory of exchange rate determination 5. Fixed Exchange Rate 3 ECO365
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Equilibrium in the Forex market The uncovered interest parity condition is This is the fundamental equation of the asset approach to exchange rates . This holds when the Forex market is in equilibrium. 4 ECO365
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Equilibrium in the Forex market Let us look at an example. First the data …… 5 ECO365
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Equilibrium in the Forex market Then we plot the data …. . 6 ECO365
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Equilibrium in the Forex market Increase in the domestic interest rate, i $ 7 ECO365
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Equilibrium in the Forex market Decrease in the foreign interest rate, i 8 ECO365
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Equilibrium in the Forex market Decrease in expected exchange rate E e $/ 9 ECO365
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Equilibrium in the Forex market Once we know the expected exchange rate and the interest rates, we can compute the spot exchange rate. But where do interest rates come from? Answer : From the money market equilibrium. 10 ECO365
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Money market equilibrium in the S.R. Key assumptions in the Long Run approach : The price level is fully flexible and adjusts to bring the money market to equilibrium. The nominal interest rate is equal to the sum of the world real interest rate and domestic inflation. 11 ECO365
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Key assumptions in the Short Run approach : The price level is fixed or “sticky”. This nominal rigidity arises due to long-term labor contracts and/or menu costs, for example. The nominal interest rate is fully flexible and adjusts to bring the money market to equilibrium. 12
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This note was uploaded on 04/03/2012 for the course ECO 365 taught by Professor Jordimondria during the Spring '08 term at University of Toronto- Toronto.

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lecture4 - ECO365 Topic 4 Exchange Rates And The Short Run...

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