Chapter 18 Differences in the monetary policies of various

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Chapter 18: Exchange Rates

Chapter Summary:

The open economy model is expanded to include different currencies. The

concept of purchasing power parity for tradable goods is defined, as are the concepts

of nominal and real exchange rates. The purchasing power parity condition is

shown to be a powerful predictor of changes in real exchange rates over time,

Differences in the monetary policies of various countries may be expected to

exert powerful influences on nominal exchange rates while leaving real exchange

rates unchanged. On the other hand, countries which attempt to maintain a fixed

nominal exchange rate must adapt their monetary policies to bring their nominal

exchange rate target into alignment with the real exchange rate. Movements of

international reserves in a fixed exchange rate system (such as the Bretton Woods

System), are supposed to automatically change the nominal quantity of money; the

central bank must passively respond to changes in international reserves. In this

the hazards of this approach. It is also shown that price and wage stickiness,

immobility of capital and labor, and structural differences in the economy make

adjustments very difficult in a fixed exchange rate system.

Chapter Outline:

I. Different Currencies and Exchange Rates

II. Interest-Rate Parity

IV. Flexible Exchange Rates : A Comparison

Teaching Tips:

1. The Economist magazine has a wealth of information on international reserves,

nominal interest rates, nominal exchange rates, economic growth rates in the back

2. The presentation in this chapter used equations rather than diagrams to illustrate

3. The last two chapters contain a lot of material and constitute a brief survey of

international finance. Adequate time must be reserved toward the end of the course

for covering these topics in depth.

4. Students may intuitively feel that a “strong dollar” is good for the economy. The

theory presented in the chapter implies that the real exchange rate is determined by

Answers to review questions, pg. 465

1. The nominal exchange rate is the rate at which one currency can be traded

for another in the foreign exchange market. The real exchange rate adjusts the

2. The condition is based on the theory that arbitrage (buying goods in

markets where the price is low and selling them in markets where the price is high)

3. Interest rate parity is based on the concept of arbitrage in asset markets.

Assuming that the real exchange rate is one (PPP holds), then the differences in

4. In a fixed exchange rate system, monetary policy must produce an inflation

rate compatible with the targeted exchange rate. Increases in the supply of money

will create inflation which would put downward pressure on the nominal exchange

rate. For example consider a country with a targeted nominal exchange rate of 2. If

5. The real exchange rate in the long run will tend to be equal to one,

therefore, differences in the ratio of the price level in the two countries must be

accommodated by movements in the nominal exchange rate. The main advantage of

Answers to Problems for discussion, pg. 465-466

7. a. In order to maintain its exchange rate target, the central bank could

increase the nominal money supply to accommodate the increased demand for

8. Answers may vary, but in general, expect the data to confirm that the

9. a. The U.S. was facing a balance of payments deficit because the nominal

rate overvalued the U.S. dollar. The foreign exchange and gold reserves of the U.S.

were decreasing and the nation’s leaders were unwilling to sacrifice domestic

economic policies for the sake of maintaining the value of the dollar in foreign

exchange markets.

b. Doubling the price of gold was one option; that would be a severe

10. a. In this case the real exchange rate deviates from the nominal exchange

rate. Perhaps the cost of shipping gold between London and New York can explain

part of this deviation. If our New Yorker spends his $1000 on 200 ounces of gold and

ships it to London, where he sells it for 200L. He then purchases $1200 with the

proceeds, pays the shipping fees of $10 (1% of $1000 shipped). His profit is $190.

b. The Londoner can purchase 200 ounces of gold, ship it, and sell it in NY

11. When the bond is purchased, a futures contract for the same amount can be

purchased at the same time. The euros earned when the bond matures can be used