Lecture 5: Cross- Country Comparisons Using Exchange Rates & PPP (Cost-of-Living) Adjustments

Nominal Market Exchange Rate (Emkt)

• Number of foreign currency units it takes to buy 1 unit of domestic currency.

• P^foreign / P^domestic

(do not adjsut currencies)

appreciation

increase in the value of one currency in terms of another Emkt ↑

depreciation

decrease in the value of one currency relative to another Emkt ↓

appreciation and depreciation example

Real Exchange Rate (RER)

the price of foreign goods in terms of the price of domestic goods (all in the same currency.)

• E P^domestic / P^foreign

• Real Appreciation- RER goes up.

• Real Depreciation- RER goes down.

Distinguish between RER and Emkt

Emkt- has to do with the relative price of currencies in 2 countries.

RER- has to do with the relative price of goods in 2 countries.

example:

What are the 2 problems with using nominal market exchange rate?

1) Cost of living difference, an Emkt does not fully encapsulate the purchasing power of of foreign currencies.

2) Emkt fluctuates dramatically wihtout reason.

ex: What if the Emkt of japan rose from 100 to 125 Yen/$? RGDP in Jamam would decrease artifically, but there is no change in production.

Purchasing Power Parity Exchange Rate Eppp

Equalized the cost of a typical “basket” of goods & services in a given country to the cost of the same basket in a reference country,

• Based on the law of one price which states that if the RER is not equal to one arbitrage will occur (traders will buy in the cheaper market and sell in the more expensive one, leading to prices going up in the cheaper market, and down in the more expensive market leading RER to equal one.

• P foreign basket/ P domestic basket

example

review big mac article

HOw od you know if a currency is overvalued based off of market exchange rate

if its is greater than one it is undervalued

if it is smaller than one it is over valued

overvaluation/ undervaluation formula

((Eppp - Emkt)/ Emkt) x 100%