exchange rate determination ( PPP (absolute PPP (misleading because (will…
exchange rate determination
will not give the exchange rate that equilibrates trade in goods and services because of the existence of non traded goods.
it give a nation an exchange rate that equilibrates trade in goods and services while completely disregarding the capital account.
the equilibrium exchange rate is equal to the ration of the price levels .
the change in exchange rate over time should be proportional to the relative change in the price level in the two nations over the some period.
R_1 = (P_1/P_0)/(P
_0) . R_0
the ratio of the price of non-traded to traded goods and services is systematically higher in developed nations than in developing nations.
the Balassa-Samuelson effect
results from labor productivity in traded goods being higher in developed nations and developing countries, but about the same in many non traded goods
since the general price index includes prices of both trade and non traded good and services and prices of the latter are not equalized by international trade but are relatively higher in developed countries,
relative PPP will tend to overvalue exchange rates for developed nations and undervalue them for developing nations
monetary approach under fixed exchange rates
= 1/v = desired ratio
P = domestic price level
Y = real output
PY = GDP
inversely related to i
= the money multiplier
D = domestic component of the nation's monetary base.
F = foreign component
an increase in the demand for money can be satisfied either by an increase in D or and out flow of the international reserves or balance of payments surplus F
and increase in D and M_s in the face of unchanged M_d, flows out of the nation and leads to a fall in F (a deficit in the balance of payments.
monetary approach under flexible exchange rates
balance of payments disequilibria are immediately corrected by automatic changes in exchange rates without any international flow of money or reserves.
under a flexible exchange rate system the nation retains dominant control over its money supply and monetary policy.
the actual exchange value of a nation's currency in terms of other currencies is determined by the rate of growth of the money supply and real income relative to the growth of money supply and real income.
flex ex helps shield the world from monetary excess
monetary approach to exchange rate determination
R = P/P*
_s/M_s = K
P/P = M_sK
expectations, interest differentials and exchange rate
monetarists assume and foreign bond are perfect substitutes. the interest differential between two countries will always equal the expected change in the exchange rate between the two currencies.
i -i* = EA
an increase in the expected rate of inflation in a nation leads to an immediate equal depreciation
portfolio balance model and exchange rates
extended portfolio balance model
i = i* + EA - RP
M D F PAGE 463
portfolio balance model