International Parity Conditions in Equilibrium Flashcards
what is the law of one price
all else being equal (no
transaction costs or restrictions) a product’s price should be
the same in all markets
when prices are in Dif currencies, how do you calculate the law of one piece
P$ x S = P¥
P$ - price of the product in US dollars S
- spot exchange rate (S, yen per dollar)
P¥ - price of the product in Japanese yen
what is the absolute theory of purchasing power parity?
is a concept in economics that suggests that exchange rates between two currencies should adjust so that the same basket of goods and services has the same price when expressed in those currencies
what is relative PPP?
relative change in prices between countries over a period time. suggests that changes in exchange rates over time should reflect changes in relative price levels (inflation rates) between two countries.
DEALS WITH INFLATION
Imagine two countries, Country A and Country B. According to RPPP, if Country A’s inflation rate is higher than Country B’s, the currency of Country A should depreciate (lose value) relative to the currency of Country B. This depreciation is expected to offset the difference in price levels, making the goods from Country A relatively cheaper for Country B.
- Empirical tests of both relative and absolute PPP show:
- PPP tends to not be accurate in predicting future exchange rates
– PPP holds up well over the very long term but is poor for short
term estimates - The theory holds better for countries with relatively high rates of
inflation and underdeveloped capital markets
what is the international fisher effect?
it’s an idea that explains how changes in nominal interest rates and expected inflation rates in different countries can impact exchange rates. If the nominal interest rate in one country is higher than in another, it implies that the first country may have higher expected inflation rates. higher interest= higher inflation which means you gotta depreciate your currency
what is the fisher effect?
if the nominal interest rate in one country is higher than in another country, the currency of the country with the higher interest rate should depreciate (lose value) relative to the currency of the country with the lower interest rate. In other words, higher nominal interest rates should lead to a weaker currency.
what is a nominal interest rate? (fisher effect)
This is the interest rate you see in the bank or on loans, and it’s the rate that’s actually paid or earned in money terms.
what is a real interest rate? (fisher effect)
The real interest rate is the nominal interest rate adjusted for inflation. It tells you how much your money’s purchasing power will change if you invest it or save it.
forward rates as an unbiased predictor ?
To say that forward rates are an unbiased predictor means that they are a reliable indicator of what the future exchange rate is likely to be. In other words, forward rates are expected to be quite accurate in predicting where exchange rates will be in the future. the idea of forward rates as an unbiased predictor means that the market’s best estimate for future exchange rates, as reflected in the forward rates, should, on average, be a reliable and close indicator of the actual future exchange rates
if the forward exchange rate is higher than the current spot exchange rate, then…
it’s said to have a “forward premium.” This means that the foreign currency is more expensive to buy in the future compared to today.
what is a forward discount?
If the forward exchange rate is lower than the current spot exchange rate, it’s called a “forward discount.” This indicates that the foreign currency is cheaper to buy in the future compared to today.
what is covered interest abirtrage?
covered interest arbitrage allows you to profit from interest rate differentials while ensuring that exchange rate movements do not erode your gains. It’s a risk-free strategy when executed correctly, as it leverages the differences in interest rates between two countrie
what is interest rate parity?
it means that when you invest in two different currencies, you should earn the same return, regardless of which currency you choose, after accounting for any expected changes in exchange rates. shows the relationship between nominal interest rates and expected exchange rates
