Solutions chapter 3 exchange rates i the monetary

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Solutions Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run S-15
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Answer: Each of these factors hinders trade more in the short run than in the long run. Specifically, each is a reason to expect that the condition of frictionless trade is not satisfied. For this reason, PPP is more likely to hold in the long run than in the short run. (1) Transactions costs. Over longer periods of time, producers generally face decreas- ing average costs (as fixed costs become variable costs in the long run). Therefore, the average cost associated with a given transaction should decrease. (2) Nontraded goods. Goods that are not traded among countries cannot be arbi- traged. Since intercountry arbitrage is required for PPP, nontraded goods will prevent exchange rates from completely adjusting to PPP. Examples of nontraded goods in- clude many services that require a physical presence on site to complete the work. There are many of these, ranging from plumbers to hairdressers. (3) Imperfect competition. Imperfect competition implies that producers of differen- tiated products have the ability to influence prices. In the short run, these firms may either collude to prevent price adjustment, or they may engage in dramatic changes in price (e.g., price wars) designed to capture market share. These collusion agree- ments and price wars generally are not long-lasting. (4) Price stickiness. In the short run, prices may be inflexible for several reasons. Firms may face menu costs, or fear that price adjustments will adversely affect market share. Firms also may have wage contracts that are set in nominal terms. However, in the long run, these costs associated with changing prices dissipate, either because menu costs decrease over time or because firms and workers renegotiate wage contracts in the long run. As markets become more integrated, PPP should become a better predictor of ex- change rate movements. For PPP to hold, we have to assume frictionless trade. The more integrated markets are, the closer they are to achieving frictionless trade. 7. Consider two countries, Japan and Korea. In 1996, Japan experienced relatively slow output growth (1%), whereas Korea had relatively robust output growth (6%). Sup- pose the Bank of Japan allowed the money supply to grow by 2% each year, whereas the Bank of Korea chose to maintain relatively high money growth of 12% per year. For the following questions, use the simple monetary model (where L is constant). You will find it easiest to treat Korea as the home country and Japan as the foreign country. a. What is the inflation rate in Korea? In Japan? Answer: K K g K K 12% 6% 6% J J g J J 2% 1% 1% b. What is the expected rate of depreciation in the Korean won relative to the Japanese yen? Answer: % E e won ( K J ) 6% 1% 5%.You can check this by using the following expression from the monetary model: % E e won ( K g K ) ( J g J ).
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