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Figure 2 Purchasing Power Parity, United States/United Kingdom, 1973–2014 (Index: March 1973 = 100.)

Figure 2 Purchasing Power Parity, United States/United Kingdom, 1973–2014 (Index: March 1973 = 100.)

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Factors That Affect Exchange Rates

in the Long Run

• Relative price levels

Trade barriers

Preferences for domestic versus foreign

goods

Productivity



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Summary Table 1 Factors That Affect

Exchange Rates in the Long Run



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Exchange Rates in the Short Run: A

Supply and Demand Analysis

• An exchange rate is the price of domestic

assets in terms of foreign assets

• Supply curve for domestic assets

– Assume amount of domestic assets is fixed

(supply curve is vertical)



• Demand curve for domestic assets

– Most important determinant is the relative

expected return of domestic assets

– At lower current values of the dollar (everything

else equal), the quantity demanded of dollar

assets is higher

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Figure 3 Equilibrium in the Foreign

Exchange Market



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Explaining Changes in Exchange

Rates

• Shifts in the demand for domestic assets

– Domestic interest rate

– Foreign interest rate

– Expected future exchange rate



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Figure 4 Response to an Increase in

the Domestic Interest Rate, iD



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Figure 5 Response to an Increase in

the Foreign Interest Rate, iF



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Figure 6 Response to an Increase in the

Expected Future Exchange Rate, Eet+1



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Summary Table 2

Factors That

Shift the

Demand Curve

for Domestic

Assets and Affect

the Exchange

Rate



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Application: Effects of Changes in Interest

Rates on the Equilibrium Exchange Rate



• Changes in Interest Rates

– When domestic real interest rates raise, the

domestic currency appreciates.

– When domestic interest rates rise due to an

expected increase in inflation, the domestic

currency depreciates.



• Changes in the Money Supply

– A higher domestic money supply causes the

domestic currency to depreciate.



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Figure 7 Effect of a Rise in the Domestic Interest

Rate as a Result of an Increase in Expected Inflation



Exchange Rate, Et

(euros/$)



S

Step 1. A rise in the domestic real interest as a

result of an increase in expected inflation shifts

the demand curve to the left . . .

Step 2. leading to a fall in the exchange rate.



E1



E2



1



2



D2



D1



Quantity of Dollar Assets



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Figure 2 Purchasing Power Parity, United States/United Kingdom, 1973–2014 (Index: March 1973 = 100.)

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