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  Slides for Chapter 9:Determinants of the Real Exchange Rate International Macroeconomics  Schmitt-Groh´e Uribe Woodford Columbia UniversityApril 8, 2018 1  International Macroeconomics, Chapter 9   Schmitt-Groh´e, Uribe, Woodford The LOOP ã  LOOP stands for the Law of One Price. ã  The law of one price says that a good should cost the same abroadand at home when its price is measured in the same currency.Formally, if the LOOP holds for good  i , then P  i  =  P  ∗ i  S, where P  i  = domestic currency price of good  i.P  ∗ i  = foreign currency price of good  i.S   = nominal exchange rate, defined as the domestic currency priceof 1 unit of foreign currency.Examples of goods for which the LOOP holds: Commodities:  Gold, Oil, Wheat, Luxury Consumer Goods:  Hermes neckties, MontBlanc pens,Rolex watches, etc.Examples of goods for which the LOOP fails: Personal Services:  health, restaurant meals, haircuts, etc. Local Goods:  housing, transportation. 2  International Macroeconomics, Chapter 9   Schmitt-Groh´e, Uribe, Woodford Reasons Why the LOOP May Fail ã  a good has non-traded inputs such as: –  labor –  rent –  electricity ã  government policies/regulations (taxes) ã  barriers to trade (tariffs, quotas) ã  International price discrimination, such as pricing to market (pharmaceclothing) 3  International Macroeconomics, Chapter 9   Schmitt-Groh´e, Uribe, Woodford PPP ã  PPP stands for Purchasing Power Parity. ã  PPP generalizes the LOOP to baskets of goods instead of individualgoods. Let P   = domestic currency price of a domestic basket of goods. P  ∗ = foreign currency price of a foreign basket of goods S   = nominal exchange rate (domestic currency per unit of foreigncurrency). ã  The real exchange rate (RER), denoted e  =  SP  ∗ P  (*)In words, the real exchange rate is the relative price of a foreignbasket of goods in terms of comparable domestic baskets of goods. ã  When  e  increases the foreign country becomes relatively moreexpensive and we say that the real exchange rate depreciated. Similarly,when  e  decreases the foreign country becomes relatively cheper andwe say that the real exchange rate appreciated. ã  if   e  = 1, we say that PPP holds. 4
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