# International Economics Study Set 8

## Quiz 15 :Price Levels and the Exchange Rate in the Long Run

Suppose Russia's inflation rate is 100 percent over one year but the inflation rate in Switzerland is only 5 percent. According to relative PPP, what should happen over the year to the Swiss franc's exchange rate against the Russian ruble?
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Purchasing power parity ( PPP )is the measure which is used to measure the economic variables in different countries. According to the purchasing power parity condition the goods in an economy should cost the same in another economy after the exchange rates are considered.Relative purchasing power parity relates to the changes in any two economies. The changes that take place in the expected inflation rates to that of the changes in their exchange rates over a period. It predicts that inflation differentials are matched by change in the exchange rate.
Given,
Inflation rate in country R = 100%
Inflation rate in country S = 5%
Calculate the inflation differential as follows:
Thus, the inflation differential is
.
According to PPP , the ruble should depreciate by approximately 95% against the franc.Under relative PPP , the franc/ruble exchange rate would
with inflation rates of 100 percent in country R and 5 percent in country S. The other way of stating the same is that the franc is expected to appreciate against the ruble by 95%.

Discuss why it is often asserted that exporters suffer when their home currencies appreciate in real terms against foreign currencies and prosper when their home currencies depreciate in real terms.
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Unlike nominal exchange rate which refers to the domestic price of foreign exchange, real exchange rate measures the cost of foreign goods relative to domestic goods. It is the relative price of goods across countries. The real exchange rate denoted as R is defined as
An increase in R refers to depreciation of the real exchange rate, which means, the relative prices of foreign goods has risen or the relative price of domestic goods has fallen.
When the relative price of domestic goods falls, exports become cheaper and thus export demand increases. This will benefit the domestic exporter and thus prospers them.
Another reason for increase in foreign demand for exports is the rise in export demand for non-tradable goods also. This also increases the benefits of the exporters.
On the other hand, a decrease in R refers to appreciation of the real exchange rate which means the relative prices of domestic goods increases.
As a result, exports become expensive and the export demand falls; leading to a loss to the exporters.

Other things equal, how would you expect the following shifts to affect a currency's real exchange rate against foreign currencies? a. The overall level of spending doesn't change, but domestic residents decide to spend more of their income on nontraded products and less on tradables. b. Foreign residents shift their demand away from their own goods and toward the home country's exports.
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(a)Since real exchange rate is the ratio between the prices of tradable goods to non-tradable goods, the change in the composition of total spending towards non-tradable goods affects the real exchange rate.
When domestic residents shift their expenditure pattern to buy more of non-tradable goods, the price of non-tradable goods will increase. As a result, there is an increase in the general domestic price level.
As a result, the real exchange rate falls that is it appreciates domestic currency against the foreign currency.
(b)When people of foreign country demand more goods produced in domestic country, it implies the foreign demand for domestic exports increases.
In such case, the domestic prices increases, relative to the foreign price and causes the real exchange rate to fall. As a result, the domestic currency appreciates against the foreign currency.

Large-scale wars typically bring a suspension of international trading and financial activities. Exchange rates lose much of their relevance under these conditions, but once the war is over, governments wishing to fix exchange rates face the problem of deciding what the new rates should be. The PPP theory has often been applied to this problem of postwar exchange rate realignment. Imagine that you are a British Chancellor of the Exchequer and that World War I has just ended. Explain how you would figure out the dollar/pound exchange rate implied by PPP. When might it be a bad idea to use the PPP theory in this way?
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In the late 1970s, Britain seemed to have struck it rich. Having developed its North Sea oil-producing fields in earlier years, Britain suddenly found its real income higher as a result of a dramatic increase in world oil prices in 1979-1980. In the early 1980s, however, oil prices receded as the world economy slid into a deep recession and world oil demand faltered. In the following chart, we show index numbers for the average real exchange rate of the pound against several foreign currencies. (Such average index numbers are called real effective exchange rates.) A rise in one of these numbers indicates a real appreciation of the pound, that is, an increase in Britain's price level relative to the average price level abroad measured in pounds. A fall is a real depreciation. Real Effective Exchange Rate of the Pound Sterling, 1976-1984 (1980 = 100) Source: International Monetary Fund, International Financial Statistics. The real exchange rate measures are based on indices of net output prices called value-added deflators. Use the clues we have given about the British economy to explain the rise and fall of the pound's real effective exchange rate between 1978 and 1984. Pay particular attention to the role of nontradables.
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Explain how permanent shifts in national real money demand functions affect real and nominal exchange rates in the long run.
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At the end of World War I, the Treaty of Versailles imposed an indemnity on Germany, a large annual payment from it to the victorious Allies. (Many historians believe this indemnity played a role in destabilizing financial markets in the interwar period and even in bringing on World War II.) In the 1920s, economists John Maynard Keynes and Bertil Ohlin had a spirited debate in the Economic Journal over the possibility that the transfer payment would impose a "secondary burden" on Germany by worsening its terms of trade. Use the theory developed in this chapter to discuss the mechanisms through which a permanent transfer from Poland to the Czech Republic would affect the real zloty/koruna exchange rate in the long run.
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Continuing with the preceding problem, discuss how the transfer would affect the long-run nominal exchange rate between the two currencies.
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A country imposes a tariff on imports from abroad. How does this action change the long-run real exchange rate between the home and foreign currencies? How is the long-run nominal exchange rate affected?
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Imagine two identical countries have restricted imports to identical levels, but one has done so using tariffs while the other has done so using quotas. After these policies are in place, both countries experience identical, balanced expansions of domestic spending. Where should the demand expansion cause a greater real currency appreciation, in the tariff-using country or in the quota-using country?
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Explain how the nominal dollar/euro exchange rate would be affected (all else equal) by permanent changes in the expected rate of real depreciation of the dollar against the euro.
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Can you suggest an event that would cause a country's nominal interest rate to rise and its currency to appreciate simultaneously, in a world of perfectly flexible prices?
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Suppose the expected real interest rate in the United States is 9 percent per year while that in Europe is 3 percent per year. What do you expect to happen to the real dollar/euro exchange rate over the next year?
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In the short run of a model with sticky prices, a reduction in the money supply raises the nominal interest rate and appreciates the currency (see Chapter 4). What happens to the expected real interest rate? Explain why the subsequent path of the real exchange rate satisfies the real interest parity condition.
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Discuss the following statement: "When a change in a country's nominal interest rate is caused by a rise in the expected real interest rate, the domestic currency appreciates. When the change is caused by a rise in expected inflation, the currency depreciates." (It may help to refer back to Chapter 4.)
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Nominal interest rates are quoted at a variety of maturities, corresponding to different lengths of loans. For example, in late 2004 the U.S. government could take out ten-year loans at an annual interest rate of slightly over 4 percent, whereas the annual rate it paid on loans of only three months' duration was slightly under 2 percent. (An annualized interest rate of 2 percent on a three-month loan means that if you borrow a dollar, you repay $1.005 =$1 + (3/12) × \$0.02 at the end of three months.) Typically, though not always, long-term interest rates are above short-term rates, as in the preceding example from 2004. In terms of the Fisher effect, what would that pattern say about expected inflation and/or the expected future real interest rate?
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