Lecture 9

Question 1

International parity conditions

Answer 1

• Covered interest rate parity (CIP)
• uncovered interest rate parity (UIP)
• absolute purchasing power parity (PPP)
• relative purchasing power
• fisher effect

Question 2

Absolute purchasing power parity (PPP)

Answer 2

• ER as a ratio of price levels
• If the absolute PPP holds, then the internal purchasing power of a currency is equal to the external purchasing power of the same currency in another country.
• Violation of the absolute PPP implies it is cheaper to buy from one country and sell at a higher price in another country.

Question 3

Relative purchasing power

Answer 3

• change in ER by inflation differential

Question 4

Fisher effect

Answer 4

• expected inflation rate = nominal interest rate - real interest rate

Question 5

Summary of PPP

Answer 5

• PPP theory specifies a precise relationship between the relative inflation rates of two countries and their exchange rate

Question 6

Summary of IFE

Answer 6

• IFE specifies a precise relationship between relative interest rates of two countries and their exchange rates

Question 7

Law of one price

Answer 7

• two things equal to each other must sell for the same price
• prevails when the same or equivalent things are trading at the same price across different locations/markets