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Unformatted text preview: e. What is the expected rate of real depreciation for the United States (versus the United Kingdom)? Answer: From (d), the real exchange rate will decrease by 0.03. Therefore, the rate of real depreciation is equal to 2 2.5% ( 52 0.03 / 1.20). This implies a real appreciation in the United States relative to the United Kingdom. f. What is the expected rate of nominal depreciation for the United States (versus the United Kingdom)? Answer: The expected rate of nominal depreciation can be calculated based on the inflation differential plus the expected real depreciation from (e). In this case, the inflation differential is 2 1% and the expected real appreciation is 2 2.5%, so the expected nominal depreciation is 2 3.5%. That is, we expect a 3.5% appreciation in the U.S. dollar relative to the British pound. g. What do you predict will be the dollar price of one pound a year from now? Answer: The current nominal exchange rate is $2 per pound and we expect a 3.5% appreciation in the dollar (from [f]). Therefore, the expected exchange rate in one year is equal to $1.93 ( 5 $2 3 (1 2 0.035). 6. Describe how each of the following factors might explain why PPP is a better guide for exchange rate movements in the long run versus the short run: (1) transactions costs, (2) nontraded goods, (3) imperfect competition, and (4) price stickiness. As mar- kets become increasingly integrated, do you suspect PPP will become a more useful guide in the future? Why or why not? Solutions n Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run S-15 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....
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- Winter '13
- Exchange Rate, japan, Foreign exchange market, United States dollar