When the euro appreciates

EIFM Seminar 5 – week commencing Nov 8th 2021

Question 1: When the euro appreciates, are you more likely to drink California wine or French wine?

You are more likely to drink California wine because the euro appreciation makes French wine relatively more expensive than California wine.

Question 2: “A country is always worse off when its currency is weak (falls in value).” Is this statement true, false, or uncertain? Explain your answer.

False. Although a weak currency has the negative effect of making it more expensive to buy foreign goods or to travel abroad, it may help domestic industry. Domestic goods become cheaper relative to foreign goods, and the demand for domestically produced goods increases. The resulting higher sales of domestic products may lead to higher employment, a beneficial effect on the economy.

Question 3: When the U.S. dollar depreciates, what happens to exports and imports in the United States?

U.S. dollar depreciation makes U.S. domestic goods cheaper, thus both domestic and foreign consumers buy more U.S.-produced goods. At the same time, imported goods become more expensive since they require more dollars per foreign currency to purchase. Thus, U.S. exports will increase and imports into the United States will decrease.

Question 4: If the Japanese price level rises by 5% relative to the price level in the United States, what does the theory of purchasing power parity predict will happen to the value of the Japanese yen in terms of dollars?

It predicts that the value of the yen will fall 5% in terms of dollars.

Question 5: Explain the difference between absolute PPP and relative PPP. How might the distinction between traded and non-traded goods be relevant to testing for PPP?

PPP theory comes in two forms: one is based on a strict interpretation of the law of one price and is termed “absolute PPP”, while the other is a “weaker” variation known as “relative PPP”

The absolute version of PPP holds that if one takes a bundle of goods in one country and compares the price of that bundle with an identical bundle of goods sold in a foreign country, converted by the exchange rate into a common currency of measurement, then the prices will be equal

Where E is the exchange rate defined as DC units per unit of FC, P is the price of a bundle of goods expressed in the DC, and P* is the price of an identical bundle of goods in the foreign country expressed in terms of the FC

The relative PPP theory argues that the exchange rate will adjust by the amount of the inflation differential between two economies

Where is the percentage change in the exchange rate, is the domestic inflation rate, and is the foreign inflation rate

Relative PPP can be expected to hold even when absolute PPP does not hold

PPP is based the assumption that all goods are traded across borders to allow for arbitrage in international goods market

However, a significant proportion of the bundle of goods consumed are non-traded

Non-traded goods are those that cannot be traded internationally at a profit, such as houses and certain services such as a haircut or restaurant food

PPP is more likely to hold for traded than non-traded goods. This is because the price of traded goods will tend to be kept in line by international competition, while the price of non-traded goods will be determined predominantly by domestic supply and demand considerations

Question 6: Explain with reference to the Balassa-Samuelson model why it is that the price of non-traded goods are cheaper in developing countries than in developed countries.

The lower relative price of non-traded goods in poor countries has been explained by Balassa-Samuelson model, which makes the assumptions below

Labour productivity in rich countries is higher than in poor countries

The productivity differential occurs predominantly in the tradables rather than the non-tradables sector

Wages are assumed to be the same in the tradables and non-tradables sectors within each economy and positively related to productivity

Prices are positively related to wages and negatively related to productivity

Balassa-Samuelson model predicts that

Developing country’s low productivity in traded sector leads to the low wage in this sector

Developing country’s low wage in traded sector leads to low wage in non-traded sector, even though its productivity in this sector is the same as in developed countries

Developing country’s low wage in non-traded sector leads to low price in that sector, relative to that in developed country

Question 7: Explain what you understand by purchasing power parity theory. How do you account for its poor performance at explaining exchange rate movements since 1973?

The prediction of PPP is born out in the very long run. However, the consensus estimates suggest that the speed of convergence to PPP is extremely slow

The PPP theory often has poor predictive power in the short run; the short-run deviations from PPP are large and volatile

There have been many explanations put forward to explain the general failure of exchange rates to adjust in line with PPP theory

Statistical problems