the goods of the other country C Appreciation and depreciation 1 In a flexible

The goods of the other country c appreciation and

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the goods of the other country C) Appreciation and depreciation 1. In a flexible-exchange-rate system, when e nom falls, the domestic currency has undergone a nominal depreciation (or it has become weaker); when e nom rises, the domestic currency has become stronger and has undergone a nominal appreciation 2. In a fixed-exchange-rate system, a weakening of the currency is called a devaluation, a strengthening is called a revaluation 3. We also use the terms real appreciation and real depreciation to refer to changes in the real exchange rate Numerical Problem 1 is a simple example of appreciation and depreciation. D) Purchasing power parity 1. To examine the relationship between the nominal exchange rate and the real exchange rate, think first about a simple case in which all countries produce the same goods, which are freely traded a. If there were no transportation costs, the real exchange rate would have to be e = 1, or else everyone would buy goods where they were cheaper b. Setting e = 1 in Eq. (13.1) gives P = P For / e nom (13.2) c. This means that similar goods have the same price in terms of the same currency, a concept known as purchasing power parity , or PPP d. Empirical evidence shows that purchasing power parity holds in the long run but not in the short run because in reality, countries produce different goods, because some goods aren’t traded, and because there are transportation costs and legal barriers to trade 2. When PPP doesn’t hold, using Eq. (13.1), we can decompose changes in the real exchange rate into parts e/e = e nom / e nom + P/P P For / P For
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Chapter 13 Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy 9 3. This can be rearranged as e nom / e nom = e/e + π For π (13.3) 4. Thus a nominal appreciation is due to a real appreciation or a lower rate of inflation than in the foreign country 5. In the special case in which the real exchange rate doesn’t change, so that e/e = 0, the resulting equation in Eq. (13.3) is called relative purchasing power parity , since nominal exchange-rate movements reflect only changes in inflation a. Relative purchasing power parity works well as a description of exchange-rate movements in high-inflation countries, since in those countries, movements in relative inflation rates are much larger than movements in real exchange rates 6. Box 13.1: McParity a. As a test of the PPP hypothesis, the Economist magazine periodically reports on the prices of Big Mac hamburgers in different countries b. The prices, when translated into dollar terms using the nominal exchange rate, range from just over $1 in China to over $4 in Switzerland (using 2003 data), so PPP definitely doesn’t hold c. The hamburger price data forecasts movements in exchange rates (1) Hamburger prices might be expected to converge, so countries in which Big Macs are expensive may have a depreciation, while countries in which Big Macs are cheap may have an appreciation E)The real exchange rate and net exports 1. The real exchange rate (also called the terms of trade) is important because it represents the
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