W6 - Relative PPP and CIP Flashcards
When does absolute PPP hold?
If the real exchange rate Q is equal to 1
Where does absolute PPP tend to hold?
Developed countries but not for developing countries
What are the general reasons for the failure of absolute PPP?
- Trade costs
- Non-tradable
- Differentiated goods
What is the future exchange rate influenced by?
The exchange rate in the future is influenced by the inflation rate differential
How should you study Purchasing Power Parity?
You should focus on changes in the real exchange rate, rather than on its level
What is relative PPP?
The value with one currency with respect to another is going to change over time reflecting inflation differentials between those currencies
Does relative PPP hold in the long run?
Relative PPP holds in the long run between the US and the UK
When does relative PPP hold?
Relative PPP holds if the rate of depreciation of the country’s currency against the dollar is equal to the inflation differential between the countries considered
When does relative PPP holds in the long run?
If the average rate of depreciation of the domestic country’s currency against the foreign currency over a long period of time is equal to the average inflation differential
Does relative PPP hold in the short-run?
No not as well, sometimes countries can be more expensive or cheaper but averages out in the long-run
Does relative PPP hold well in practise?
Yes relative PPP holds well in the long-run empirically
What does Covered Interest Parity (CIP) suggest?
Equality of returns on comparable financial market investments when the forward foreign exchange market is used to eliminate foreign exchange risk
What would happen if CIP didn’t hold?
Arbitrage opportunities would exist
What assumptions does CIP assume?
Assumes: capital mobility, low transactions costs and taxes, equal risk. Many say any deviations in CIP can be explained largely by any deviations in these assumptions
What does CIP link?
The forward rate with the spot rate and the interest differential between the two countries
Why do individuals engage in forward contracts?
To hedge risk
Or speculate
Why is the parity condition called covered?
Because it covers the exchange risk
Does CIP hold true?
Yes largely other than in the very short-lived high frequency data
Why do deviations in CIP emerge?
- Default risk
- Exchange controls
- Political risk
What is risk premium?
An increase in return associated with the asset issuers ability to pay
