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

# Prices must be equal in all locations for any good

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Prices must be equal in all locations for any good when expressed in a common currency. Otherwise, there would be a profit opportunity from buying low and selling high. 6

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5/23/2013 4 Absolute PPP, Prices, and the Nominal Exchange Rate PPP supplies reference level for the exchange rate. Rearrange the PPP equation: 7 Absolute PPP, Prices, and the Nominal Exchange Rate Exchange rate = relative price levels of the two nations. Can predict exchange rate movements: reflect relative prices, so all we need to do is predict prices. 8
5/23/2013 5 Relative PPP, Inflation, and Exchange Rate Depreciation If true in levels of exchange rates &prices, then must be true in rates of change . Rate of change exchange rate is the rate of depreciation in the home currency (U.S. \$): 9 On the R.H.S. of the equation, assuming small changes in prices: Relative PPP, Inflation, and Exchange Rate Depreciation change in relative prices (P US /P E ) is the home- foreign inflation differential: 10

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5/23/2013 6 This gives us Relative PPP : Relative PPP, Inflation, and Exchange Rate Depreciation Rate of depreciation of the nominal exchange rate equals the inflation differential. 11 Relative PPP is derived from Absolute PPP Relative PPP, Inflation, and Exchange Rate Depreciation If Absolute PPP holds then Relative PPP must hold also. BUT converse need not be true. 12
5/23/2013 7 Where Are We Now? PPP theory (absolute or relative) li k b i & h suggests strong link between price & exchange rates .

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