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CH03- Exchange Rates I - Monetary Approach in the LR-part1 - 2 slides- S13

Levels or rates of change stop and ask some questions

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(levels or rates of change) Stop and ask some questions: Do the data support PPP? 13 Where do price levels come from? Empirical Evidence on PPP 14
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5/23/2013 8 E MPIRICAL E VIDENCE ON PPP 15 How Fast is Convergence to PPP? Two useful measures: Speed of convergence : how quickly deviations from PPP disappear over time (about 15%/year). Half-life: Time for half of deviations from PPP to disappear 16 (about four years).
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5/23/2013 9 Explaining Deviations from PPP? Examine Assumptions Transaction costs Non-traded goods Imperfect competition and legal obstacles Price stickiness 17 The Big Mac Index The Economist uses Big Macs to evaluate whether currencies are undervalued or overvalued. Now use Starbucks tall latte , Apples iPod, & iTunes http://www.economist.com/markets/Bigmac/ 18
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5/23/2013 10 PPP as an Exchange Rate Theory In levels we have Absolute PPP : In rates of change we have Relative PPP : 19 PPP AS AN E XCHANGE R ATE T HEORY Now we need to ask: where do price levels / inflation rates come from? 20 To answer this question, we look @ monetary theory .
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5/23/2013 11 Overview of Money Market Recall that by definition, “money” is anything that is a : store of value unit of account medium of exchange For our purposes money is 21 the stock of liquid assets used to finance transactions: M1 – currency in circulation + demand deposits T HE M ONETARY A PPROACH : A S IMPLE M ODEL OF P RICES 22
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5/23/2013 12 The Monetary Approach: A Simple Model of the Exchange Rate Recall that PPP shows relationship between price level and exchange rates.
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