Monetary Approach to Exchange Rates Flashcards

Vocabulary flashcards based on lecture notes about the monetary approach to exchange rates.

Law of One Price (LOOP)

States that in the absence of trade frictions, identical goods in different locations must sell for the same price when expressed in a common currency.

Purchasing Power Parity (PPP)

A macro-level extension of LOOP applied to baskets of goods.

Absolute PPP

States that price levels in two countries are equal when expressed in a common currency.

Real Exchange Rate

Measures how many US baskets are needed to buy one European basket.

Real Depreciation

When the real exchange rate rises.

Real Appreciation

When the real exchange rate falls.

Relative PPP

Expresses the rate of depreciation of the nominal exchange rate as equal to the inflation differential between countries.

PPP Deviations

Decay slowly, about 15% per year, meaning half-life of about 4 years.

Functions of Money

Store of value, unit of account, medium of exchange.

Money Supply

Controlled by central banks, often measured by monetary aggregates (M0, M1, M2).

Simple Model (Quantity Theory)

Money demand proportional to nominal income.

Money Market Equilibrium

Price level determined by money supply and demand.

Monetary Model of Price Levels

Applies separately for US and Europe.

Monetary Model of Exchange Rate

The fundamental equation of the monetary approach to exchange rates.

Inflation Rate

Inflation is money growth minus real income growth.

Exchange Rate Depreciation Rate

Exchange rate depreciation depends on differences in money growth and real income growth rates.

Hyperinflation

Defined as inflation > 50% per month or ~1000% per year.

Currency Reform

Replacing old currency units by new units at large ratios (e.g., 10,000:1).

Fisher Effect

Nominal interest rate (i) adjusts one-for-one with expected inflation.

Real Interest Parity

Arbitrage ensures equal expected real interest rates across countries in the long run.