{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

ECON 1102 Week 10

# The exchange rate is 110 1 real exchange rate p p f e

This preview shows pages 23–33. Sign up to view the full content.

Japanese computer costs ¥242,000. The exchange rate is ¥110 = \$1. 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

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
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)

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
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

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
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
29 How well does purchasing power parity (PPP) explain exchange rates Explains long term movements in the exchange rate Assumptions low transportation costs all goods and services tradeable perfectly mobile capital flows

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
Limitations of PPP Empirical evidence provides stronger support for PPP in the long-run (i.e. over decades or centuries), than in the short-run. Non-traded goods. Some types of goods are difficult to trade internationally (classic example is a haircut). Trade barriers such as tariffs and quotas. Tend to raise costs of transporting goods internationally.
31 2. What determines the nominal exchange rate (2) Demand for and supply of Australian dollars model D \$A S \$A 0 Quantity of \$A Price of \$A (e) Equilibrium exchange rate (e) appreciation depreciation

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
32 Demand for Australian dollars D \$A 0 Quantity of \$A Price of \$A (e) Shifts in D \$A World real GDP Domestic prices relative to foreign prices Preferences/tastes Interest rate differential D \$A to: buy Australian exports inward incomes/transfers purchase Australian assets
This is the end of the preview. Sign up to access the rest of the document.