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Exchange Rates ((Chap 3: Exchange Rates Part 1 (3.1: Exchange Rates and…
Exchange Rates
Chap 3: Exchange Rates Part 1
3.2: Money Market Equilibirum
Definition of Money
3 points: Store of Value, unit of account and medium of exchange
Money Supply
Central Banks
• Quantity Theory of Money Equation
More supply, weaker dollar. More demand stronger dollar
3.1: Exchange Rates and Prices in the Long Run
Law of One Price
states that in the absence of trade frictions (such as transport costs and tariffs), and under conditions of free competition and price flexibility (where no individual seller or buyer has the power to manipulate prices, and prices can freely adjust), identical goods sold in different locations must sell for the same price when prices are expressed in a common currency.
Purchasing Power Parity
o Purchasing power parity (PPP) is a popular metric used by macroeconomic analysts.
• Real Exchange Rate vs Nominal Exchange Rate
While the nominal exchange rate tells how much foreign currency can be exchanged for a unit of domestic currency, the real exchange rate tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country
• Absolute vs Relative PPP
Law of One Price vs. Market Imperfections
3.3 Monetary Approach
• Forecasting Exchange Rates
Hyperinflations
Inflation at an extremely high rate (exponentially high)
3.5 Monetary Regime and Exchange Rate Regimes
Monetary Regime
Long-run nominal anchoring and short-run flexibility are the characteristics of the policy framework
Nominal Anchors
o Money Supply Target
Inflation equals excess rate of money supply growth above real income growth
o Inflation Target Plus interest rate policy
Home inflation is home nominal interest rate minus foreign real interest rate
o Exchange Rate Target
Rate of depreciation equals the inflation differential
3.4 Money, Interest Rates and Prices
Real Interest Parity
This remarkable result states the following: if PPP and UIP hold, then expected real interest rates are equalized across countries.
Fisher Effect
A rise in the expected inflation rate in a country will lead to an equal rise in its nominal interest rate.