International Economics Tenth Edition Exchange

Transcript:International Economics Tenth Edition Exchange:
International Economics Tenth Edition Exchange Rate Determination Dominick Salvatore John Wiley & Sons, Inc. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc. CHAPTER F I F T E E N 15 Learning Goals: Understand the purchasing power parity theory and why it does not work in the short run Understand how the monetary and the portfolio balance models of the exchange rate work Understand the causes of exchange rate overshooting Understand why exchange rates are so difficult to forecast Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc. Introduction Since floating rates began in 1973, international financial flows are now larger than trade flows, shifting the focus to monetary theories of exchange rates. Monetary exchange rate theories view the exchange rate as a purely financial phenomenon, and tend to explain exchange rate volatility and disequilibria in the short run. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc. Purchasing-Power Parity Theory Absolute Purchasing Power Parity The equilibrium exchange rate between two currencies equals the ratio of price levels in both nations. R= P/P* Where R = exchange rate or spot rate P = general price level in home nation P* = general price level in foreign nation Example: If the price of a bushel of wheat is $1 in the United States and €1 in the European Monetary Union, then the exchange rate between the dollar and the euro should be R = $1/ €1 = 1. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc. Purchasing-Power Parity Theory Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc. The law of one price A given commodity should have the same price (so that the purchasing power of the two currencies is at parity) in both countries when expressed in terms of the same currency. Caused by commodity arbitrage. Purchasing-Power Parity Theory Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc. Absolute PPP theory can be misleading because: Appears to give exchange rate that equilibrates trade in goods and services while ignoring capital account. At exchange rate that equilibrates trade in goods and services, capital inflows would produce surplus in balance of payments, while capital outflows would lead to deficits. Purchasing-Power Parity Theory Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc. Absolute PPP theory can be misleading because: