EC 111 1st Edition Lecture 17PREVIOUS LECTUREI. A Special Cost of Unexpected InflationII. The Cost of InflationIII. ConclusionIV. Chapter 18: IntroductionV. Closed vs Open EconomyVI. Variables That Influence Net ExportsVII. Flow of Goods and ServicesVIII. Trade Surplus and DeficitsIX. The Increasing Openness of the US EconomyX. The Flow of CapitalXI. Variables That Influence Net Capital OutputXII. The Equality of Net Exports and Net Capital OutputXIII. Saving, Investment, and International Flows of Goods and ServicesCURRENT LECTUREI. Case Study: The US Trade DeficitII. The Nominal Exchange RateIII. Appreciation and DepreciationIV. The Real Exchange RateV. Interpreting the Real Exchange RateVI. Purchasing Power ParityVII. Purchasing Power Parity and its ImplicationsVIII. Limitations of the Purchasing Power Parity TheoryCASE STUDY: THE US TRADE DEFICIT- A country, like a person, can go into debt for good reasons or bad ones. A trade deficit is not necessarily a problem, but might be a symptom of a problem- Long-term trade deficit isn’t necessarily goodo Can brig in foreigners to loan out and can potentially give Americans jobsTHE NOMINAL EXCHANGE RATEThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- Nominal Exchange Rate: the rate at which one country’s currency trades for another- We express all exchange rates as foreign currency per unit of domestic currencyAPPRECIATION AND DEPRECIATION- Appreciation (or “strengthening”): an increase in the value of a currency as measured by the amount of foreign currency it can buyo It takes more foreign currency to buy 1 US dollaro A “strong” dollar causes US goods to become more expensive compared to foreign goods, so US imports will rise and US exports will fall- Depreciation (or “weakening”): a decrease in the value of a currency as measured by the amountof foreign currency as measured by the amount of foreign currency it can buyo It takes less foreign currency to buy 1 US dollaro A “weak” dollar causes US goods to become less expensive compared to foreign products, so US exports rise and imports fallTHE REAL EXCHANGE RATE- Real Exchange Rate: the rate at which the goods and services of one country trade for the goods and services of anothero Computed as: (exP)/P*  P=domestic price in domestic currency P*=foreign price in foreign currency e=nominal exchange rateINTERPRETING THE REAL EXCHANGE RATE- Many people often interpret the real exchange rate as:o 0.75 Japanese Big Macs per US Big Mac THIS IS INCORRECT- The correct interpretation:o One US Big Mac can be exchanged (traded) for 0.75 of a Japanese Big Mac- This interpretation is also called the terms of tradePURCHASING POWER PARITY - Purchasing Power Parity (PPP): a theory of exchange rates whereby a unit of any currency shouldbe able to buy the same quantity of goods in all countries- Based on the Law of One Price:o The notion that a good should sell for the same price in all markets- Implies that nominal exchange rates adjust to equalize the price of basket of goods across countriesPURCHASING POWER PARITY AND ITS IMPLICATIONS- E=P*/P- Implies that the nominal exchange rate between two countries should equal the ratio of price levels- If two countries have the same different inflation rates then e will change over timeo If inflation is higher in Mexico than it is in the US, then P* rises faster than P. so e rises the dollar appreciation against the Peso.o If inflation is higher in the US than in Japan, then P rises faster than P*. So e falls. The dollar appreciates against the yenLIMITATIONS OF THE PPP THEORY- Two reasons why exchange rates do not always adjust to equalize prices across countries1) Many goods cannot be equally tradeda. Examples: haircuts or going to the moviesb. Price differences on such goods cannot be arbitraged away2) Foreign goods and domestic are not perfect substitutesa. Example: some US consumers prefer Toyotas over Chevys or vice versab. Price differences reflect tastes and preferences ***We will not have to calculate PPP on exam 3. Just know the definitions, concepts, and the limitations of