L9 Flashcards
PPP tries to explain
how inflation effects exch
PPP model
Relies on law of one price- assest should sell at same price after taking exch into consid
PPP hold
Doesnt in ST- large persistent deviations
holds in LT
Inflation in PPP
= (P1-Po)/Po
PPP- internal and external PP
should equal each other
1/Poa = 1/SoPPP X 1/Pob
or
SoPPP= Poa/Pob
Internal PP
1/Poa= 1/Price level country A current period
External PP in Currency A
1/ SoPPP X 1/Pob = 1/current spot exch predicted by PPP x 1/ Price level country B
What if SoPPP doesnt equal Poa/ Pob
Abtrirage opp
PPP curr predictions
Overvalued- should deprecate
Undervalued- Should aprreciate
variations due to
* tariffs and quotas
* Trans cost
* Non competitive Market
Overvaluation of Curr1 means undervaluation of Curr2
Means External PP of Cur1 > Internal PP
Curr2 Internal PP> External PP
Why Absolute PPP doesnt hold
Changes in relative Prices
No substitutes for traded foods
Non traded goods- Housing
changes in BOP
Relative PPP
used as market is imperfect, prcies of same baskest of products in diff countries wont be the same
the rate should be similar- % change in exch should be roughly equal to the diff in inflat between 2 countries
% change PPP exchange
ePPP= (S1PPP-SoPPP)/SoPPP
Inflation 2 countries
A= (P1/Po) -1
B is the same
Hence 1+ePPP = (1+InflatA)/(1+Inflat B)
ePPP roughly equals The diff in inflation rates
RPPP
Tries to predicted the % change in exch from the diff of Inflation as:
* Inflation lowers PP of money= inflat diff across countries should change nominal exchange rate to compensate
Sum of PPP
Higher Inflation= Higher imports, lower exports= Local curr deprecation
vice versa
IFE- international Fisher Effect
Diff in nominal I between countries can be used to predict changes in exch
Hence: -Fisher effect
When Inflat ^, central banks should rise I
Real Return
R= Inflation - I
This can be expressed in terms of PP
If IFE holds
E(ePPP)= ( Id- If)
countries with high inflation should have high nominal I
IFE empirical evidence
doesnt support in ST
LT suggests validity
Implication of IFE
Cur with High I will have high Inflat. The high Inflat will cause a deprec cause of the PPP effect
Hence
* foreign investors are adversely effected by high inflat if they try to cap on high I
Limitations of IFE
relies on fisher and PPP effect
*Fisher Limit- diff between nominal I and actual Inflat is not consistnet
*PPP limit- other country features besides Inflat can effect Exch movement
Fisher effect
Nominal I should reflect Inflat expectations
Diff between IRP PPP IFE- IRP
IRP- focus on why FWD differes from spotand on degree of diff that should exist. relates to specific point in time
