Flexible Exchange Rate

ECONOMICS 3200, FALL 2003, ALSTON

STUDY GUIDE FOR MIDTERM # 3 (ALSO SEE THE QUESTIONS/PROBLEMS AT THE END OF EACH CHAPTER)

Essay Questions and Answers for Chap 19

1. Explain the law of one price and the theory of purchasing power parity. Why doesn’t the purchasing power parity explain all exchange rate movements? What factors determine long-run exchange rates?

With no trade barriers and low transport costs, the law of one price states that the price of traded goods should be the same in all countries. The purchasing power parity theory extends the law of one price to total economies. PPP states that exchange rates should adjust to reflect changes in the price levels between two countries. PPP may fail to fully explain exchange rates because goods are not identical, and price levels include traded and nontraded goods and services. Long-run exchange rates are determined by domestic price level relative to foreign price levels, trade barriers, import and export demand, and productivity.

2. Explain the interest parity condition. What key assumption underlies this condition? What factors affect the returns on domestic and foreign deposits?

The interest parity condition states that returns on domestic and foreign deposits will be equal. The key assumption for this condition is capital mobility. The return on domestic deposits is equal to the domestic interest rate. The return on foreign deposits is equal to the foreign interest rate minus the expected rate of appreciation of the domestic currency.

3. Explain and show graphically the effect of a decrease in the expected future exchange rate on the equilibrium exchange rate.

A fall in the expected future exchange rate shifts RF to the right, causing a depreciation of the domestic exchange rate. RF shifts to the right, from [pic]to [pic] The equilibrium exchange rate falls from E1 to E2.

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4. Explain and show graphically the effect of a decrease in the domestic...