International Finance Theory EXAM II (CH 5-7)

We will start with some review

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Exchange Rate (E$/€)

The price of one euro measured in dollars

Depreciation

Currency becomes cheaper in terms of another

Price Level (P)

The average price of goods and services produced and consumes in an economy

Inflation (𝝅)

% rate at which the price level rises over time

What is E

Exchange rate, domestic currency price of foreign currency.

If E goes up, what does that do to currency?

domestic currency depreciates

If E goes down, what does that do to currency?

domestic currency appreciates

E$/€ up, what does that mean for dollar and euro?

Dollar depreciates, euro appreciates

Short run:

Period where prices do not have enough time to adjust (prices are sticky)

Long Run

Period where prices have enough time to adjust (prices are flexible)

Nominal

in money/unit terms

Real

adjusted for prices

Law of one price

An identical good in different competitive markets must sell for the same price if transportation costs and trade barriers are unimportant

Arbitrage

Buying and selling to make profit from price gap

Why does Arbitrage not hold eventually?

Many people do it, demand decreases for one place and increases for another until the price converges.

Law Of One Price equation:

P(Domestic) = E x P*(Foreign)

Purchasing power parity (PPP):

the law of one price applied to whole baskets of goods across countries.The exchange rate moves until currencies have equal purchasing power.

Purchasing Power

How much stuff a unit of currency can buy

If the U.S. basket is $200 and the Canadian basket is C$400, for PPP to hold the exchange rate between (E(C$)/US$) both countries should be

400/200 → 2/1 → 2(C$)/US$

What is the two forms of PPP

• Absolute PPP

• Relative PPP

Absolute PPP

Price level match after currency conversion between countries. The exchange rate = the ratio of price levels

Relative PPP

the change in the exchange rate equals the inflation difference between 2 countries

Absolute PPP Equation

E$/€ = P_US / P_EU

Relative PPP Equation

Exchange rate, t (current period) - E, t-1 (previous period) / E, t-1 (previous period)

Which type of PPP holds even if the other does not?

Relative PPP

Monetary approach

uses monetary factors (money supply, interest rate, output) to predict long-run exchange rates, built on absolute PPP plus money market equilibrium.

Chain of Money Supply level (a one-time permanent change in Ms)

• Mˢ↑ → P↑

• P_US↑ → E$/€↑

• Result: a proportional rise in P and E, with no effect on R or Y.

Explain Chain of Money Supply level in words (Mˢ↑ → P↑)

More money chasing (means money is less valuable) the same goods pushes prices up proportionally.

Explain Chain of Money Supply level in words (P_US↑ → E$/€↑)

by PPP, a higher U.S. price level means each dollar buys less, so the dollar depreciates proportionally.

What is the Money Equilibrium Point Formula

P = Mˢ / L(R, Y)

Using the monetary approach, the long-run nominal exchange rate depends on

1. Relative Money Supply

2. Money Demand Factors

Relative Money Supply

Ratio or comparison between the total money supply of one country and the money supply of another country

Money demand factors

factors that change the quantity demanded

• Interest Rates

• Income

Impact of interest rate rise in the long run, describe the chain

• R$ ↑ → L(R$,Yus) ↓

• L (R,Y)↓ → P↑

• P↑ → E↑

Describe the interest Rate Chain in Words

• R$↑ → L↓: a higher rate makes holding cash costly, so people hold less real money.

• L↓ → P↑ (because P = Mˢ/L): the same money supply is chasing less money demand.

• P↑ → E↑: by Absolute PPP, the dollar depreciates.

What is Price equation

• P = Mˢ/L

Impact from domestic production & Income (output) rise in the long run, describe the chain (if US was domestic country)

• Yus ↑ → L(R$,Yus) ↑</p></li><li><p>L(R$,Yus) ↑ → P↓

• P↓ → E↓

Describe the Output Chain in Words

• Yus ↑ → L(R$,Yus) ↑: more transactions need more money.</p></li><li><p>L(R$,Yus) ↑ → P↓: Fixed money supply needs to keep up with high demand, so we lower the price

• P↓ → E↓: by Abs PPP, dollar appreciates

All three channels (money supply, interest rate, and output change) in the long run follow which chain

• Start with a change in the money supply or demand

• Leads to a Price Change

• Which leads to an exchange rate change (By Absolute PPP)

What are the 2 cases that explain change of interest rates in the long run?

1. A one-time permanent change in the money supply causes a one-time change in the price level & exchange rate (CH 4)

2. A change in the growth rate of the money supply causes a change in the inflation rate, then a change in the exchange rate growth rate.

Growth Rate

Measures the % change in a variable from one period to the next. Measures how fast something is increasing

Inflation Rate

Growth rate of the price level, how fast prices are rising.

Fisher effect

A rise in domestic inflation causes an equal rise in the domestic nominal interest rate in the long run, holding other factors constant.

Fisher Effect simple equation

𝑅$ − 𝑅€ = 𝜋^e 𝑈𝑆− 𝜋𝐸𝑈

Which 2 equations is the Fisher Effect derived from

1. Interest parity (R$ − R€ = (Eᵉ − E)/E)

2. Relative PPP (expected form): (E^e $/€,t - E $/€, t-1)/E $/€, t-1 = π_US − π_EU

Interest parity

The interest gap between the two countries equals the expected depreciation. Investors expect identical returns whether they invest domestically or abroad after currency conversion.

Relative PPP (expected form)

Expected depreciation equals the inflation gap between two countries

What do relative PPP and the Interest parity Condition have in common that makes the simple fisher effect equation?

Expected depreciation rate ((Eᵉ − E)/E)

Does inflation affect output in the long run and why?

No because:

• Output is determined by real factors (labor, capital, tech, & producing)

• Money is neutral in the long run

Does inflation affect output in the short run and why?

Yes because:

• Prices do not adjust to changes in interest rates; therefore, people spend more/less because money is more available or cheaper to borrow. More demand means producing more.

Why logical reason on why the Fisher Effect happens?

Lenders want to be paid back the money with the same purchasing power.

Explain and draw a graph of the Money Supply Shock if the CB unexpectedly increases the growth rate of the money supply at time 0 (Monetary Approach to Exchange Rate in long run)

• Slope = π

• Slope after change: π + Δπ

• The graph after t0 should have a steeper slope (meaning more money supply)

More money supply means what for inflation?

More Inflation

Explain and draw a graph of the interest rate response if the CB unexpectedly increases the growth rate of the money supply at time 0 (Monetary Approach to Exchange Rate in the long run)

• Money growth = faster price growth rate = higher inflation growth rate

• With the Fisher effect (R$ − R€ = π^e_US − π^e_EU) and we assume EU inflation is 0%.

• π ↑ → R$ must rise too by change of π (R2$ = R1$ + Δπ)

• Jumps because of expectations adjust immediately

• On graph, the change is a jump up

What are two ways price is affected in Monetary Approach graph?

1. Slope Change

2. Jump at t0

Explain and draw a graph of the price level response if the CB unexpectedly increases the growth rate of the money supply at time 0 (Monetary Approach to Exchange Rate in the long run)

Money growth = faster price growth rate

2 ways Price is affected:

1. Slope change: Inflation (price growth rate) goes from π → π + Δπ, so prices rise faster afterward.

2. Jump at t0: Interest rate rise, which lowers real money demand (R$ ↑ → L(R$,Y_us) ↓)

   1. P_us = M^s / L(R$,Y_us), a smaller denominator make P jump

What are two ways exchange rate is affected in Monetary Approach graph?

1. Slope Change

2. Jump at t0

Explain and draw a graph of the exchange rate response if the CB unexpectedly increases the growth rate of the money supply at time 0 (Monetary Approach to Exchange Rate in the long run)

• Absolute PPP states that E$/€ = P_US / P_EU</p></li><li><p>We know M^s growth rate ↑ → P growth rate ↑</p></li><li><p>Therefore, E is affected in two ways </p><ul><li><p>Slope Change: E grows at the same rate as P_us through Abs PPP, so E$/€ rises from π → π + Δπ. The slope change means that $ depreciates faster over time.

• Jump at t0: The jump P_us causes an equal jump in E$/€, so dollar depreciates immediately

Main assumption difference between model of w/ and w/o PPP.

1. Model without PPP: Short run transition to Long Run (Prices are sticky, one time money supply jump)

2. Model with PPP: Purely Long run (Prices are flexible, money growth rate)

Main interest rate difference between model of w/ and w/o PPP.

• Model without PPP: R$ ↓ on impact, then R$ ↑ during transition, no change in the R$ in the long run

• Model with PPP: R$ rises permanently (jump)

Main Interest Rate takeaway between model w/ and w/o PPP

• W/o a lower interest rate came from a weaker currency (makes people willing to hold extra cash)

• W/ PPP, higher interest comes from a weaker currency (Fisher effect)

• So any explanation of E using interest rates must account for why the interest rate was moved. Same rate means different things.

Overall effect when Money growth rate rises

Money Supply Line Steeper

Money Growth rises, what is the effect on the interest rate

The interest rate rises by change in inflation (Fisher effect)

Money Growth rises, what is the effect on the Price Level

The Price level jumps, then rise at a faster rate

Money Growth rises, what is the effect on the exchange rate

E jumps up (dollar depreciates immediately), then continues to rise at a faster rate.

Shortcoming of Absolute PPP

Has little empirical support. Identical baskets converted to a single currency cost substantially different amounts in different countries.

What are the 3 reason on why Relative PPP sometimes predict exchange rates poorly?

1. Trade Barriers & non-tradeable goods

2. Imperfect Competition

3. Difference in the measure of average prices for the basket of goods & services

What is main trade barrier?

Transportation costs and government trade restrictions

Non-tradable goods

goods and services that cannot be practically traded across borders (services).

Why is there imperfect competition

Monopolies $ Oligopolies can influence pricing; they practice price discrimination

Price discrimination

Charging different prices to different groups for the same product, reflecting variations in cost, demand, or consumer purchasing power.

Big Mac Index

From the difference in average price measurement for goods and services, a semi-hilarious illustration of PPP comparing the price of Big Macs across different countries (not the same)

Because of the shortcoming of PPP what do we add?

Real Exchange Rate

Real Exchange Rate

rate in which goods and services in one country trade for goods and services in another. The relative cost/value of baskets of goods in one country compared to another. Measure what you can actually buy not currency amount.

Real Exchange rate equation

q$/€ = (E$/€ × P_EU) / P_US

Explain this equation: q$/€ = (E$/€ × P_EU) / P_US

How many euro baskets can you get for one US Basket