Economics Flashcards
CIRP
Difference between 2 countries interest rates should equal the forward exchange rate discount/premium adjusting for the expected difference in exchange rate btwn the time money is borrowed and returned.
CIRP holds
OR currency exchange rates are driven by interest rate differentials coz of arbitrage it must hold.
However, F is a poor predictor of the future Spot exchange rates
CIRP formula
F f/d = S f/d {1+if (Act/360)/1+id(Act/360)}
UIRP
The expected percentage change in the spot rate = the difference in int rates of the 2 countries
Formula = if- id
OR
Interest rate differences drive currency exchange rates
However it does not hold coz the assumption that an investor is risk neutral and that the high int rate currency will depreciate does not work in real life
Purchasing power parity
Relationship between interest rates and inflation differentials
Law of one price - assumes identical goods should trade at the same price across countries when valued at the same currency
Why is UIRP assumed not to hold
Most times the higher int rate currency is expected to depreciate while in real life it appreciates,
Investors are assumed to be risk neutral when they are not
Why does Purchasing power parity not hold?
Transaction costs across countries,
Trade impediments
Explain Absolute, Relative and Ex-Ante versions of PPP
Absolute -
Relative - percentage change in spot rates (currency rates) = changes in inflation differentials
Ex-Ante - EXPECTED percentage change in spot rates (currency rates) = expected differences in interest rates
Key word is expected in ex-ante and simply inflation rates differentials in relative
Purchasing Power Parity
Inflation differences drive exchange rates in the long run if it persists
The fisher effect and real int rate parity
Combines both int rate differentials and inflation differentials
Nominal rate = real rate + expected inflation
if - id = (rf - rd) + ( einflation f - einfaltion d)
International Fisher Effect
if - id = expected inflation f - expected inflation d
Mundell-Fleming Model
Short-term impact of both monetary and fiscal policy on exchange rates
Portfolio balance approach
Long term impact of only fiscal policy on exchange rates
Monetary approach
Impact of only monetary policy on exchange rates - inflation is the only factor
3 approaches to look at effect of monetary and fiscal policy on exchange rates
- Mundell-Fleming model
- Portfolio balance approach
- Monetary approach
Pull factors
Factors that encourage capital flow into a county
1. Relative price stability
2. Flexible exchange rate regime
3. Improved fiscal position
4. Privatization of state owned enterprises
Push factors
Factors that lead to capital movement out of the country
1. Investors seeking higher yields due to low domestic yields
2. Fund managers seeking to diversify portfolio
