Lecture 4 Notes

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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 countries will depreciate by approximately the difference in inflation rates EX.)If the home currency is the US with an inflation of 10%, the foreign currency, Japan, inflation rate is 6%. The expected change in exchange rate is -4%. In other words, the US dollar will depreciate by 4%. Why does this make sense?

US goods are more expensive, the demand for the $ decreases, therefore the value of dollar decreases

**PPP states - Currencies on high inflation countries will depreciate by approximately the difference in inflation rate and vice - versa

We are looking at the rate of change for this equation:
dS/S = [dPI(country1)/PI(country1)] - [dPI$/PI$]

Rate of the change of the spot rate compared to the rate of change in the inflation in both and foreign countries
Using derivatives to indicate we are talking about a rate of change

PPP: Does it work?
Over time (LR) - yes, gives us relatively accurate predictions of exchange rates SR - no
PPP is more of a band then a line - there is some margin for error due to the differences in price indices

PPP line demonstrates there is an inverse relationship: If the difference in the relationship is positive (foreign inflation is greater than home inflation) the home currency will appreciate. Change in the spot rate decreases.

When off of PPP line, forces realign them: we begin to import more, demand more for foreign exchange which drives up the price currency. the dollar depreciates.

Fisher Effect:
States that the nominal interest rate can be stated in terms of the real interest rate plus an inflation component. The link between inflation rates and interest rates is expressed in the fisher effect.

(1+i) = (1+r)(1+Pie)

where i = nominal interest rate
r = real interest rate
pie = expected inflation rate

i is approximately equal to r + pie

Real rates would converge across countries because if there are no restrictions to capital and funds can go anywhere you would put our money in the...
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