ECON 101 Lecture Notes - Lecture 7: Purchasing Power Parity, Exchange Rate, Fisher Equation

64 views2 pages
Economics 101
Lori Leachman
Part 7 Lecture
Unholy Trinity of Exchange Rate Theory
o Can only have 2 of the 3:
Fixed Exchange Rate
Capital Mobility
Monetary Autonomy
o Combinations
If you fix and want monetary autonomy, you need capital controls (limit on currency
exchanges, restrictions on foreign ownership, minimum stay requirement for money...etc)
- limit money leaving, keep money stay, reduce money leaving - China
If you want monetary autonomy and capital mobility, you must float - US / EU
If you want fix and capital mobility, must give up monetary autonomy - Mexico,
Thailand, Hong Kong
Purchasing Power Parity (PPP)
o Exchange rate adjusts to equilibrate the prices on similar goods
P = P* * e or P / P* = e or log P - log P* = log e
Rate of dom P - rate offoreign P = rate ofe
o Ties exchange rate to current account (CA)
o Explains Long Run trends in exchange rate (5-10 years)
o Big mac index gages PPP
o *Trend/Rule
If P > P* (if domestic > foreign): buy foreign goods/services
FC appreciates, $ depreciates, e increases
Causes exports to fall (decrease S) and imports to rise (increase D)
If P < P* (if domestic < foreign): buy domestic goods/services
FC depreciates, $ appreciates, e decreases
Causes exports to rise (increase S) and imports to fall (decrease D)
o Changes in Prices (P)
Change in inflation
Change in productivity - falling prices
Change in regulation - deregulation leads to falling prices
Change in industrial structure - competition leads to falling prices
Change in innovation - falling prices
Interest Rate Parity (IRP)
o Ties exchange rate movements to changes in demands for assets due to changing returns (r)
or changing risk; risk-adjusted returns
o Ties exchange rate to FA (Financial account)
o Explains daily, minute-by-minute changes in exchange rate; short run changes (0-2 years)
o IRP dominates over PPP - there is higher volume of money being transferred for assets than for
goods/services
o r* - r = E(e) where r = risk-adjusted return
If r < r* (if higher foreign returns than domestic): buy foreign assets
FC appreciates, $ depreciates, e increases
ForA increases (increase D) and Adom decreases (decrease S)
If r > r* (if lower foreign returns than domestic): buy domestic assets
FC depreciates, $ appreciates, e decreases
ForA decreases (decreases D) and Adom increases (increases S)
o Changes in Real Return
Change in inflation, no change in interest rate (fisher equation: i = r + p)
Inflation with no monetary action
Change in interest rate, no change in inflation (fisher equation: i = r + p)
Monetary action not targeting inflation
find more resources at oneclass.com
find more resources at oneclass.com
Unlock document

This preview shows half of the first page of the document.
Unlock all 2 pages and 3 million more documents.

Already have an account? Log in

Document Summary

Part 7 lecture: unholy trinity of exchange rate theory, can only have 2 of the 3, fixed exchange rate, capital mobility, monetary autonomy, combinations. If you fix and want monetary autonomy, you need capital controls (limit on currency exchanges, restrictions on foreign ownership, minimum stay requirement for moneyetc) Limit money leaving, keep money stay, reduce money leaving - china. If you want monetary autonomy and capital mobility, you must float - us / eu. If you want fix and capital mobility, must give up monetary autonomy - mexico, If p > p* (if domestic > foreign): buy foreign goods/services: fc appreciates, $ depreciates, e increases, causes exports to fall (decrease s) and imports to rise (increase d) Irp dominates over ppp - there is higher volume of money being transferred for assets than for goods/services r* - r = e(e) where r = risk-adjusted return.

Get access

Grade+20% off
$8 USD/m$10 USD/m
Billed $96 USD annually
Grade+
Homework Help
Study Guides
Textbook Solutions
Class Notes
Textbook Notes
Booster Class
40 Verified Answers
Class+
$8 USD/m
Billed $96 USD annually
Class+
Homework Help
Study Guides
Textbook Solutions
Class Notes
Textbook Notes
Booster Class
30 Verified Answers

Related Documents