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Week-7-Solution-for-week-6

The document discusses the effects of shifts in spending on a currency's real exchange rate, indicating that increased spending on non-traded goods leads to appreciation of the real exchange rate, while a shift in foreign demand towards home country exports also results in appreciation. It further explains how permanent shifts in national real money-demand functions impact nominal exchange rates without altering real exchange rates in the long run, highlighting the relationship between money demand, price levels, and exchange rates. The general model suggests that real exchange rates depend on output market conditions and shifts in demand can lead to depreciation or appreciation of the real exchange rate.

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13 views

Week-7-Solution-for-week-6

The document discusses the effects of shifts in spending on a currency's real exchange rate, indicating that increased spending on non-traded goods leads to appreciation of the real exchange rate, while a shift in foreign demand towards home country exports also results in appreciation. It further explains how permanent shifts in national real money-demand functions impact nominal exchange rates without altering real exchange rates in the long run, highlighting the relationship between money demand, price levels, and exchange rates. The general model suggests that real exchange rates depend on output market conditions and shifts in demand can lead to depreciation or appreciation of the real exchange rate.

Uploaded by

ktthuy6102003
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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International Finance

Solutions for Problem Set #3:


(Problem 3, 7 in Chapter 15)

Problem 1. Other things equal, how would you expect the following shifts to affect a currency’s
real exchange rate against foreign currencies?
a. The overall level of spending doesn’t change, but domestic residents decide to spend more of
their income on nontraded products and less on tradables.
b. Foreign residents shift their demand away from their own goods and toward the home country’s
exports.
Answer:
P = wPT + (1-w)PN
PN denotes prices of non-traded goods
PT denotes prices of tradable goods

q = (E x P*)/P
q: real exchange rate
E: exchange rate
P*: foreign price level
P: domestic price level

a.) Since there is a rise of non-traded goods’ price (PN rises) resulting from consumption on non-
traded goods increases, the domestic price level (P) rises compared to the foreign price level
(P*). So, the real exchange rate appreciates (q decreases).

b.) Since foreign residents shift their demand away from their own goods (P* falls) and demand
more of home country’s exports causing a rise in the price of the home country’s traded goods
(PT rises), the home price level (P) increases. So, the real exchange rate appreciates (q declines).

Problem 7. Explain how permanent shifts in national real money-demand functions affect real and
nominal exchange rates in the long-run.

Answer: General model of long-run exchange rate

E = q.P/P* = q x (M/M*) x L*(R*,Y*)/L(R,Y)

Permanent shifts in domestic real money-demand function will change the long-run equilibrium of
the nominal exchange rate but will not alter that of the real exchange rate.

For example, a permanent increase (decrease) in real money demanded will cause the domestic
price level to fall (rise) [P= M/L(R,Y)] which leads to an appreciation (depreciation) of the long-run
nominal exchange rate (E=P/P*).
1
International Finance

Under the general model, it is assumed that long-run values of real exchange rate depend just on the
demand and supply conditions of output markets. Thus

q= E.P*/P = E x (M*/M) x L(R,Y)/L*(R*,Y*)

L(.) increases → real exchange rate depreciate (q increases)

L(.) falls → real exchange rate appreciate (q falls)

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