Exchange Rates, Forex, and PPP

What is a nominal exchange rate?

The price of one currency in terms of another currency.

What is currency appreciation?

An increase in a currency's value relative to another currency.

What is currency depreciation?

A decrease in a currency's value relative to another currency.

What does dollar appreciation generally do to imports?

Makes foreign goods cheaper in dollars, all else equal.

What does dollar appreciation generally do to U.S. exports?

Makes U.S. goods more expensive to foreign buyers, all else equal.

A European product costs €100. At $1.10/€, what is its dollar price?

$110.00

What is the foreign exchange market?

The market where currencies are bought and sold.

What increases demand for U.S. dollars?

Greater foreign demand for U.S. goods, services, or financial assets.

What happens when demand for dollars rises relative to supply?

The dollar tends to appreciate.

How can higher U.S. interest rates affect the dollar?

They may attract capital inflows, increasing dollar demand and causing appreciation.

What is the real exchange rate?

A measure of relative goods prices across countries after currency conversion.

What is one real exchange rate formula?

q = eP*/P, where e is domestic currency per foreign currency.

Under q = eP*/P, what does a rise in q mean?

Foreign goods become relatively more expensive; domestic goods become relatively cheaper.

What is purchasing power parity (PPP)?

The idea that exchange rates adjust so equivalent goods cost similarly across countries.

What is the absolute PPP formula using e = domestic currency per foreign currency?

e = P/P, where P is the domestic price level and P is foreign.

What is the Big Mac Index?

The Economist's comparison of Big Mac prices across countries as a rough PPP measure.

Why might PPP fail to hold?

Transport costs, tariffs, taxes, non-tradable services, different wages, and market differences.

How can higher domestic inflation affect a currency under PPP?

It tends to put downward pressure on the currency over time, relative to lower-inflation countries.