Econ Flashcards
What is Covered Interest Rate Parity?
- This is the only parity where international parity holds.
- This is a risk-free, arbitrage relationship
Under this condition:
- Capital flow freely
- Market stress free condition
- Spot & Forward Market is liquid
What is Uncovered Interest Rate parity?
interest rate differential: I(f) - I(d) = % of change in expected spot rate F / spot rate D
Expected return on an uncovered foreign currency investment should equal to the return on a comparable domestic currency investment.
Under UIRP, country with higher interest rate is expected to see the value of the currency?
Decreased.
If UIRP held, what does that mean?
No excess return could be gained by going long a high yielding currency & Short a low yielding currency
No incentive to shift capital from one currency to another
Empirical studies of UIRP, what does it show?
- Fail to hold over short & Medium terms
- Interest rate differentials are generally a poor predictor of future fx rate changes
- high yield currencies tend to strengthen instead of weaken
- forward fx rate are a poor indication of future spot fx rates
- Current spot fx rates are also poor predictors of future fx rates
Purchasing power Parity (PPP)
Fx rates and Inflation differentials
Basing on law of one price - identical goods should trade at the same price across countries when valued in terms of a common currency
Pf(x) = Sf/d * Pd(x)
Absolute PPP
Assumes that all domestic & foreign goods are tradable & that price indices are identical
Same good & Service, same weights
Pf = Sf/d * Pd
Sf/d = Pf/Pd
Relative PPP
Assumes these costs are constant over time
Different in Sf/d equals or similar to π f - π d (changes in fx rate = inflation differential)
The currency of high inflation country should ___ relative to currency of low inflation country.
Increase
ex ante version of PPP
Expected changes in spot rate are driven by expected differences in inflation rates
Real fx rate PPP
q (f/d) = S(f/d)*Pd/Pf = Sf/d (CPId/CPIf)
The fisher effect & Real interest rate parity formula
i(f)-i(d) = (r(f)-r(d)) - (expected π(f) - expected π(d))
Real interest parity need what condition to hold?
- UIRP
2. ex ante PPP
International fisher effect
When real interest differential = 0
interest rate differential = expected inflation rate differential
IMF 3 approach to derive long-run equilibrium
- Macroeconomic balance approach
- External sustainability approach
- Recued form econometric mode
Macroeconomic balance approach
Estimate how much fx rates need to adjust in order to close the gap between medium-term expectation for a country’s current account imbalance and that country’s normal current account imbalance (Focus on ‘real’ flows)
External sustainability approach
focuses on stocks of outstanding asset/debt - how much fx rates need to adjust to ensure that a country’s net foreign asset/GDP ratio or net foreign liability/GDP ratio stabilizes at some bench mark level (focus on financial flows)
Reduced form econometric model
estimate the equilibrium path that a currency should take on the basis of the trends in several key macro variables (e.g. net foreign asset position, terms of trade, relative productivity)
- Currency overvalued, trade surplus
- Currency Overvalued, trade deficit
- Currency undervalued, trade surplus
- Currency undervalued, trade deficit
What action do we need to bring fx - rate close to long run fair value?
- Unclear
- Encourage depreciation
- Unclear
- Encourage appreciation
Carry trade
When UIRP doesn’t hold over short and medium term, it opens up FX Carry trade.
- take long position in high yield currencies and short positions in low yield currencies (funding currencies)
- earn positive excess returns in most market conditions (low volatility
Carry trade crash risk
volatility/Perceived risk can cause these positions to unwind fast
Current account
Sum of all recorded transactions in traded good, services, income & Net transfer payment
(Similar to PnL)
Current account deficits will affect currency how?
Currency depreciation overtime
Which account is the dominant factor in determining exchange rate movement? and why?
Capital account - financial flow
- It is quicker to move comparing to the price of goods and services.
- Production of real goods and service takes time
- Current spending/production decisions reflect only purchases/sales of current production
- Expected exchange rate movement can induce very large short-term capital flows (actual fx rate sensitive to the view held by owners and managers of liquid assets.
Trade surplus - __ demand for currency – ___ pressure
Trade deficit - __ demand for currency – ___ pressure
more, upward
less, downward
Persistent surpluses/Deficits should __
Revert; surplus country currency would appreciate to the point that exports would drop, import would increase
Capital responds to interest rate differentials, risk premia and expectation fx rate movement
Capital account will rise when yield spread widens, inflation expectations tightens and risk premia spread tightens
risk premia - perceived sustainability of the country’s external balance
High yield high inflation rate country wants price stability + long term sustainable growth, what can they do?
- combat inflation by raising interest rates (Monetary)
- Lower gov debt, financial market liberalization, removal of capital flow restrictions and attraction of FDI. (economic and fiscal)
Expansionary Mundell - fleming model, what does it do and what’s the impact with it’s monetary policy and fiscal policy?
increase AD and output (GDP)
Monetary policy:
a. reduce interest rate -> increase investment & consumption spending
b. leads to capital outflows -> downward pressure on fx rates
Fiscal policy:
a. Increase spending and lower taxes
b. exerts upward pressure on interest rates (larger deficits need to be financed)
c. leads to capital inflows - upward pressure on fx rates.
Expansionary Mundell - fleming model with fixed rate, what does central bank need to do?
expansionary monetary policy:
a. central bank will have to buy its own currency & deplete fx reserves (to support currency) -> this tightens domestic credit conditions -> offsets intended expansionary policy.
Fiscal policy with fixed rate expansionary:
a. central bank will have to sell it’s currency and build reserves -> this expands domestic money supply and reinforces expansionary policy.
Under Mundell-Fleming Model, can domestic policymaker
a. Pursue independent monetary policy
b. permit capital to flow freely across national boarders
c. defend fx rate
can all three achieve at the same time?
No. to have A and c we need to put capital control on b
