Chapter_11_Prices_and_Exchange_Rates

Relative price level ratio purchasing power parity

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Relative price level ratio:
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Purchasing Power Parity PPP ( Absolute PPP ) is said to hold when, for the basket price levels P: This implies that a basket of goods purchased in two countries should cost the same in a common currency. The absolute PPP also implies that the exchange rate at which two currencies trade is equal to the relative price levels of the two countries:
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The Real Exchange Rate The relative price level ratio q is an important concept. It is called the real exchange rate Remember the key difference to avoid confusion. Nominal exchange rate E is the ratio at which currencies trade. Real exchange rate q is ratio at which goods baskets trade. The real exchange rate qE/US tells us how many U.S. baskets are needed to purchase one European basket.
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Real Appreciation and Depreciation Changes in the real exchange rate: If the real exchange rate rises more home goods needed in exchange for foreign goods intuitively called a real depreciation of the dollar . If the real exchange rate falls fewer home goods needed in exchange for foreign goods Intuitively called a real appreciation of the dollar .
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Overvaluation and Undervaluation Absolute PPP holds if and only if the real exchange rate equals 1: What if absolute PPP does not hold? If the real exchange rate is above one (by x %) foreign (European) goods are relatively expensive foreign currency (euro) is said to be overvalued (by x %). why? euros are x% dearer than they would have to be to satisfy PPP. If the real exchange rate is below one (by x %) foreign (European) goods are relatively cheap foreign currency (euro) is said to be undervalued (by x %). why? euros are x% cheaper than they would have to be to satisfy PPP.
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Absolute PPP, Prices, and the Nominal Exchange Rate We can now see that PPP supplies a reference level for what the exchange rate. Rearrange the PPP equation: PPP implies that the exchange rate at which two currencies trade is equal to the relative price levels of the two countries. PPP theory can be used to predict exchange rate movements – these simply reflect relative prices, so all we need to do is predict prices.
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Relative PPP, Inflation, and Exchange Rate Depreciation The absolute PPP equation: If this is true in levels of exchange rates and prices, then it is also true in rates of change . The rate of change in the exchange rate is the rate of depreciation in the home currency (U.S. $):
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Relative PPP, Inflation, and Exchange Rate Depreciation The rate of change in relative prices (PUS/PE) is the home-foreign inflation differential: Result is Relative PPP : Relative PPP implies that the rate of depreciation of the nominal exchange rate equals the inflation differential.
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Relative PPP, Inflation, and Exchange Rate Depreciation Relative PPP is derived from Absolute PPP If Absolute PPP holds then Relative PPP must hold also.
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