Chapter 8 Flashcards
PPP
Inflation Rates impact on ER
ER adjustments is necessary for relative PP to be the same whether buying abroad or locally
Absolute PPP
price of same basket of products in 2 diff countries should be equal when measured in a common currency
Relative PPP
real life: transportation cost, tariffs, quotas may prevent absolute form of PPP
accounts for possibility of market imperfection
rate of change in the prices of the baskets should be somewhat similar when measured in common currency, as long as TC or TB remain unchanged
PPP Example:
2 countries producing substitutes –> demand fo products should adjust as Infl. differ
high US inflation rate
–> Us increase us imports
–> Uk lower us exports (lower demand)
places upward pressure on GBP´s value
shifting of consumption from US to Uk will continue until GBP´s value has appreciated to extent that
1. price paid for british goods by US consumers are NO lower than prices for comparable products made in UK
2- Prices paid for US goods by british consumers are no higher than prices for comp. products mad in UK
Relative PPP
whatever differences exist they should remain constant
goods costing x% more should remain costing x% more
countries have their own inflation rates (allowing indep. economic policies)
–> thus relative prices of imports compared with domestic goods remain unchanged
–> freely ER assumed (so it can adjust to effect of diff. inflation policies)
–> investment flows guided by IR don´t affect the RS
Derivation of PPP
price index of home: Ph(1Ìh)
price index of foreign country:
Pf(1+If)*(1+ef)
ef = %change in value of foreign country
PPP theory suggest that ER won´t remain constant but will adjust to maintain PPP
%changes in ef should change to maintain parity in the new price index of the 2 countries
Statistical Test
for all regression lines consider: ao + a1 (1+..../1+... -1) + u ao = constant (0) a1 = slope coeff (1) u = error
Limitations PPP Test
bas period should reflect equilibrium positions since subsequent periods are evaluated in comparison to it
very difficult to choose BP
identify appropriate EQ
PPP Limitation
confounding effect (not only Infl. affects ER movements) no substitutes for traded goods in home country or subs. goods in another country (rather than buying at home) under PPP assume that real ER in the LR revert to some mean level (only temporary deviations from EQ value in the SR) --> reality: ER in Sr appear to be more volatile (substantial), however, deviations are reduced in the SR
IFE
nominal risk free IR contain real interest rate of return and anticipated inflation
Rear = return on investments to savers after accounting for expected inflation (actual return)
if real remain quite stable over LR nominal IR has to adjust over time to changes in inflation
IFE
link with PPP
IFE –> foreign currency with high IR will depreciation due to high nominal IR (which reflect high Infl)
a) currency with high IR will have high Inflation (fisher effect)
b) relative high Inflation will cause currency to depreciate (PPP effect)
nominal IR also incorporates default risk of an investment
IFE
uncovered IRP
investing abroad with NO ER protection (e.g fwd contract)
IFE contradict that high IR in a country may encourage foreign investors to invest in that country &aplacing upward pressure on currency (D>S)
high IR may contain high Inflation (which might indicate potential depreciation of foreign currency)
Derivation of IFE
r = (1+if)*(1+ef) - 1
E(r) = ih = foreign (above)
this is more related to MM securities (borrowing/investing) & looking for return (r)
grahical analysis
look for points
a) below = foreign investment
b) above = home
- -> but look which 3 possibilities
- -> foreign investment generate (OA) equal returns that domestic investments (some above some below line)
- -> but in general if same yield (OA) saver to invest at home as yield of foreign investment will be uncertain as spot rat at maturity won´t be known!!
