macroeconomics quizzes - Introduction to Macroeconomics
abdll7
vi_b.docVI. B. International Finance II
(Nominal) Exchange Rates—rates at which two currencies exchange
E$€ dollars needed to purchase one euro (price or value of the euro)
E€$ euros needed to purchase one dollar (price or value of the dollar)
E$€ = 1/ E€$
Appreciation of dollar E$€
¯
, E€$
There are markets for currency, just as for other assets and goods, that determine the currencies value.
Demand and Supply Figures
Exchange Rates and Relative Prices of Goods
EUR
P
euro price of goods produced in Europe
US
P
dollar price of goods produced in USWe can compare the price of goods across countries after converting the foreign price into units of the domestic currency,
E$€
g
EUR
P
/g
US
P
(the real exchange rate or relative price of goods across borders)
Holding the currency prices of the two goods constant, appreciation of the dollar (E$€
¯
) will lower the cost of the European goodIf the appreciation of the dollar, depreciation of the euro, was due to an increase in the supply of euro, the cost of European goods will only fall in the short-run. Why?
Exchange Rates in the Long-Run
In the long-run, the real exchange rate should be equal.
If economies are open the real exchange rate will approach one and cannot be influenced by currency supplies (Quantity Theory in open economy case)
This is called Purchasing Power Parity or the Law of One Price
E$€
g
EUR
P
/g
US
P
= 1· E$€ =
g
US
P
/g
EUR
P
changes in nominal exchanges rates reflect difference in inflation rates
