Question

#71 Suppose that both the nominal exchange rate (Mexican Peso/U.S. Dollar) is falling and that the ratio of the prices (U.S. Dollar/Mexican Peso) is also falling. If the demand for U.S. Dollars relative to the Mexican Peso is rising, which open market theory do we believe is most consistent with our economy?

a. Purchasing Power Parity b. Open Economy Model c. Both a and b d. Neither a nor b

Answer is B, but why? What exactly is Purchasing Power Parity? What exactly is the Open Economy Model? What concepts do i need to understand to be able to get to this answer?

Answer 1

The Open Economy Model is a theory where the economy in question is open to trade with the world i.e it engages not only in domestic trade but also has trading partners outside its borders. For international transactions to take place smoothly, it is important to have a mechanism where currencies can be converted in order to reflect the true prices of the commodities. The real exchange rate R is defined as the ratio of the price level abroad and the domestic price level, multiplied by the current nominal exchange rate E. The nominal exchange converts the foreign price level into domestic currency units.

Formally, R=(E.P*)/P, where the foreign price level is denoted as P* and the domestic price level as P. When the nominal exchange rate (Mexican Peso/U.S. Dollar) is falling and the ratio of the prices (U.S. Dollar/Mexican Peso) is also falling it means the dollar is appreciating as compared to the peso.

Purchasing power parity (PPP) states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. The main idea is, the purchasing power of a consumer for a fixed basket of goods and services should be constant across borders after adjusting for exchange rates.When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP.