Wednesday, May 28, 2008

Lecture 9 - Exchange Rates (continued)

Some General Notes

Study notes for the final will be distributed next week.

Some reading links on the course web page are broken and will be fixed

PPP Conditions (cont.):

excahnge rate can be viewed as purchasing power ratio between countries

As a percentage, the %Δe = difference in the inflation rates differencials of the countries

Fixed exchange rate + PPP condition

Fixed exchange rate is a shortcut to fighting inflation.
See chart: Argentina: Exchange Rate and Inflation Rate, 1992-2004.
New president appointed new economist who introduced a currency board: e =1 (Argentine peso/$). A currency board is the strongest form of a fixed exchange rate. It requires the Central Bank to have a $ for every Peso that they circulate.

Under PPP conditions, %Δe = 0 = ΠArgentina - ΠUS and therefore the Argentine inflation rate must match the US inflation rate.

Many countries fix their currency exchange rate against the dollar. Some also fix the exchange rate with the Euro as well.

(You can download The Economist screensaver from their web site. It looked pretty cool in class. :)

In Argentina, after they fixed the currency to the $, the eventually (after 3-4 yrs) achieved a low inflation rate.

In the late 1990s, Argentina couldn't sell very much and developed a significant trade deficit. So they decoupled the exchange rate which led to an immediate spike in inflation in 2002. Eventually, the economy stablized and inflation fell back down again.

The Euro

In 1999, the Euro was introduced. 1 € = 1.96 DM = 6.56 FF
ebar = DM/FF = 3.xx
ebar = 0. So, ΠFrance = ΠGermany

See graph "Convergence of Inflation Rates in the Eurozone: 1970-2007. (packet page 14) Inflation in Germany has historically been low. By pegging to the German currency, other countries "import" the low inflation rate.

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