ECON 248 12.3 A First Theory Of Exchange-Rate Determination: Purchasing-Power Parity

A type of exchange rate system where the monetary authority sets the exchange rates, meaning it fluctuates minamally.

Fixed Exchange Rate System

A type of exchange rate system where supply and demand determine the exchange rate, making it change rapidly.

Flexible Exchange Rate

A theory which tries to explain the variability of exchange rates determined by supply and demand.

Purchasing Power Parity(PPP)

According to PPP, a dollar should be able to buy the () number of goods in any Country. This is called the ().

Same, Law Of One Price

PPP implies that the nominal exchange rates of 2 Countries should also reflect the () of goods and services in those Countries(Real Exchange Rate).

Price Levels

Countries with high inflation experience currency (), while the opposite should cause ().

Depreciation, Appreciation

If Country A experiences Currency Depreciation while Country B experiences Currency Appreciation, Country B will be able to buy () of Country A’s currency.

More

To calculate changes in nominal exchange rates(ΔE) the following must be calculated

ΔE = ΔP*(Changes in Foreign Price Levels) / ΔP(Changes In Domestic Price Levels)

If a good costs more in Country I than Country II, the currency of Country I is said to be (). To solve this, a () of Country I currency would restore PPP.

Overvalued, Depreciation

If a good costs less in Country I than Country II, the currency of Country I is said to be (). To solve this, a () of Country I currency would restore PPP.

Undervalued, Appreciation

When currencies are not at PPP levels, it causes () to occur, where people seek profit by buying in one market and selling in another market for a higher price.

Arbitrage

The theory of PPP does not hold true due to the existence of () and Tradable goods which aren’t ().

Non-Tradable Goods, Perfect Substitutes

An example of a non-tradable good would be something like (), where people wouldn’t be willing to travel far just to get a price reduction.

Hair Cuts

An example of a a tradeable good which isn’t a perfect substitute would be something like () vs (), where people like those specific tastes each Country has to offer.

Canadian Beer, German Beer