Lecture 4 Notes
Parity Conditions - Lecture 4
Help to determine if foreign exchange rates are predictable.
eliminate risk doing business abroad
By parity there means there is some sort of equilibrium or equality.
4 Variables - Outline the Parity Condition
Exchange Rates
Forward Currencies
Inflation rates
Interest Rates
*Note: If parity conditions are to hold (equality) we must assume that exchange rates are fully floating and there are no capital controls
5 Parity Conditions:
Purchasing Power Parity
Relationship btw inflation and exchange rates
Fisher Effect
Inflation and Nominal Interest Rates
International Fisher Effect
Nominal interest rates and Exchange rates
Interest Rate Parity
Relates nominal interest rates to the forward premium or discount on the currency
Forward Rate
Predictor of the spot rate
Purchasing Power Parity (PPP):
Law of 1 Price
Identical goods in two different markets with no restrictions on sale or transportation costs of moving the product btw the two markets that the product prices should be the same
Conversion to the foreign currency
P$ X S = P(Euros)
S = spot exchange rate
Spot rate = P(Euros)/P$
Not workable because we are talking about specific products. Not every pair of prices will equal the spot rate Readjust the PPP
Absolute form of PPP
Extension of the law of 1 price
Applies to average prices rather than an individual product
Establish the spot rate by looking at price Indices (Price Index)
Spot rate - PI(Euros)/PI$
CPI (consumer price index) WPI (Wholesale price index)
-Problem is that the basket of goods used to determine an index is not going to be the same as the basket of goods in another country
Relative Form of PPP - accounts for market imperfections and states that the rate of price changes should be similar among markets looks at the change in the relative price indecis
% change in exchange rate = rate of inflation in one country - another country
Currencies of high inflation
Help to determine if foreign exchange rates are predictable.
eliminate risk doing business abroad
By parity there means there is some sort of equilibrium or equality.
4 Variables - Outline the Parity Condition
Exchange Rates
Forward Currencies
Inflation rates
Interest Rates
*Note: If parity conditions are to hold (equality) we must assume that exchange rates are fully floating and there are no capital controls
5 Parity Conditions:
Purchasing Power Parity
Relationship btw inflation and exchange rates
Fisher Effect
Inflation and Nominal Interest Rates
International Fisher Effect
Nominal interest rates and Exchange rates
Interest Rate Parity
Relates nominal interest rates to the forward premium or discount on the currency
Forward Rate
Predictor of the spot rate
Purchasing Power Parity (PPP):
Law of 1 Price
Identical goods in two different markets with no restrictions on sale or transportation costs of moving the product btw the two markets that the product prices should be the same
Conversion to the foreign currency
P$ X S = P(Euros)
S = spot exchange rate
Spot rate = P(Euros)/P$
Not workable because we are talking about specific products. Not every pair of prices will equal the spot rate Readjust the PPP
Absolute form of PPP
Extension of the law of 1 price
Applies to average prices rather than an individual product
Establish the spot rate by looking at price Indices (Price Index)
Spot rate - PI(Euros)/PI$
CPI (consumer price index) WPI (Wholesale price index)
-Problem is that the basket of goods used to determine an index is not going to be the same as the basket of goods in another country
Relative Form of PPP - accounts for market imperfections and states that the rate of price changes should be similar among markets looks at the change in the relative price indecis
% change in exchange rate = rate of inflation in one country - another country
Currencies of high inflation