## Empirics of Purchasing Power Parity and Exchange Rates

Empirics of Purchasing Power Parity and Exchange Rates
The foreign exchange intervention by the French government involves the sale of a
U.S. asset, the dollars it holds in the United States, and thus represents a debit item in
the U.S. financial account. The French citizens who buy the dollars may use them to
buy American goods, which would be an American current account credit, or an
American asset, which would be an American financial account credit
Suppose the company issuing the traveler’s check uses a checking account in France to
make payments. When this company pays the French restaurateur for the meal, its
payment represents a debit in the U.S. current account. The company issuing the
traveler’s check must sell assets (deplete its checking account in France) to make this
payment. This reduction in the French assets owned by that company represents a
credit in the American financial account.
Solution-
5 Macroeconomic Analysis and Intervention
A temporary tax cut shifts the DD curve to the right and, in the absence of
monetization, has no effect on the AA curve. In the below figure, this is depicted as a shift in the DD curve to D’D’, with the equilibrium moving from point 0 to point 1. If the deficit is financed by future monetization, the resulting expected long-run nominal
depreciation of the currency causes the AA curve to shift to the right to A’A’ which
gives us the equilibrium point 2. The net effect on the exchange rate is ambiguous, but
output certainly increases more than in the case of a pure fiscal shift.
A currency depreciation accompanied by a deterioration in the current account
balance could be caused by factors other than a J-curve. For example, a fall in foreign demand for domestic products worsens the current account and also lowers aggregate demand, depreciating the currency. In terms of the below figure, DD and XX undergo equal vertical shifts, to D’D’ and X’X’, respectively, resulting in a current account deficit as the equilibrium moves from point 0 to point 1. To detect a J-curve, one might check whether the prices of imports in terms of domestic goods rise when the currency is depreciating, offsetting a decline in import volume and a rise in export volume.

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Empirics of Purchasing Power Parity and Exchange Rates

Empirics of Purchasing Power Parity and Exchange Rates