ECO 304L Lecture 14: Lecture 14 Notes

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ECO 304L
M O S T A S H A R I, S H A L A H

● Closed Economy: An economy that does not interact with other economies in the world ● Open Economy: An economy that interacts freely with other economies around the world ● Exports: Goods and services that are produced domestically and sold abroad ● Imports: Goods and services that are produced abroad and sold domestically ● Foreign Exchange Transaction: Funds denominated in different currencies are exchanged or traded ● Nominal Appreciation: Home currency buys more foreign currency ● Nominal Depreciation: Home currency buys less foreign currency ● Real Exchange Rate for US: q European baskets/US bEuros/$$/US baskeEuros/European basket​ ○ Real Appreciation ■ Rise in q ■ US goods are less competitive ○ Real Depreciation ■ Fall in q ■ US goods are more competitive ● Law of One Price: If there were no trade costs, one can expect a currency to buy the same number of goods in different countries ● Arbitrage ○ Transactions that take advantage of price differences across locations ○ Arbitrage puts pressure on exchange rate until equilibrium is reached ● Purchasing Power Parity ○ A country buys the same number of baskets of goods in different countries ○ Theory of how exchange rates evolve over time ○ Currencies appreciate or depreciate to achieve purchasing power parity ○ Absolute Purchasing Power Parity
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