ECON 1102 Week 10

# Real exchange rate p p f e price in dollars price in

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Real exchange rate = P (P f / e) = price in dollars price in yen / yen-dollar exchange rate = \$A2,400 ¥ 242,000 / ¥ 110 = \$A2,400 \$A2,200 = 1.09

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Implications of The Real Exchange Rate When the real exchange rate is high , domestic goods are more expensive than foreign goods (in a common currency) When the real exchange rate is low , domestic goods are less expensive than foreign goods (in a common currency)
25 Exports determined by Real GDP in the rest of the world ( ‘X’ higher for higher world GDP) International competitiveness the real exchange rate Imports determined by Domestic (Australian) real GDP (‘M’ higher for higher domestic GDP) International competitiveness the real exchange rate The real exchange rate is a measure of international competitiveness P/(P f /e)

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Law of One Price If transportation costs are relatively small, the price of an internationally traded good must be the same in all locations. If this is not the case, then their will be profitable opportunities to buy the good in the relatively cheaper location and sell it the more expensive location. Simple idea yields a model of the exchange rate.
27 2. What determines the Nominal E xchange R ate (1) Purchasing power parity (PPP) The exchange rate ‘e’ adjusts to maintain the law of one price That is, the law of one price states that if transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations => P d x e = P f => e = P f /P d

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28 Purchasing power parity (PPP) an example The price of a car is \$A20,000 in Australia and \$US15,000 in the USA Under PPP e = P f /P d = 15,000/20,000 = 0.75 What happens if Australia experiences high inflation? The currency of a country that experiences significant inflation will tend to depreciate If P d increases to \$A30,000 e = 15,000/30,000 = 0.5