Week 6 Flashcards
What does the absolute power parity state? What is the flaw?
That the price of a goos in a foreign country will be equal to the price of the home currency * the exchange rate. So goods are identically priced once exchange rates are factored in.
In practice however this doesn’t occur due to things like:
restricted commodity movement (quotas), transportation costs, tariffs or barriers to trade, goods that do not have close substitutes in other countries, or non traded goods are included in the price indices.
What does relative purchasing power state?
That exchange rates should move relative to changes in the price levels between two points in time (the inflation level between two points). This means the rate of change in prices of the same basket of goods should be comparable when measured in a common currency (because inflation will be the same).
How do we do burgernomics?
burgernomics uses the big mac index, it tells us the relative price of a big mac in different countries. We can take the implied exchange rate from this index and compare it to the actual exchange rate to see how undervalued/overvalued a currency is to another. This is done by taking the ((actual exchange rate/implied exchange rate)-1) to get the overvaluation/undervaluation of the unit currency.
For the quoted currency we use ((implied exchange rate/actual exchange rate)-1).
We can also factor in the gdp per capita value between two countries to make it more accurate. This is done by multiplying by the gdp per capita ratio before over/undervaluation.
What does purchasing power parity assume?
Price indices for home and foreign country are equal at time = 0. Over time the prices will go up by each country’s inflation, if inflation in the home currency is greater than the foreign inflation and the exchange rate between the two does not change then consumer purchasing power is grater for foreign than home goods, meaning purchasing power parity no longer holds.
What is the purchasing power parity equation?
Does higher inflation cause depreciation or appreciation
Pf(1+inflation foreign)*(1+change in foreign currency value) = Ph(1+inflation home).
the change in foreign currency value is therefore given by (inflation home - inflation foreign)/(1+inflation foreign).
The country with the higher inflation will see it’s currency depreciate.
In a purchasing power parity graph what does being under or over the line mean?
the purchasing power parity graph marks inflation home-inflation foreign and the associated change in spot price.
If a currency pair is over or under the line it should appreciate/depreciate as necessary to return to parity.
What are some features that cause purchasing power parity not to hold?
Trade barriers, a lack of substitutable goods, nontradables(commodities not traded internationally), and barriers to international commodity arbitrage like transportation costs.
What is the International fischer effect?
it states that the nominal interest rate = expected inflation + real return. That is, it’s the interest rate that has not removed inflation. Rational consumers will need to be encourages to save by earning the real return + estimated inflation. The effect tells us that the difference in nominal interest rates is equal to the differences in inflation. This inflation can be used to dermine which country will experience more trade demand due to inflation.
The real interest rate required by savers tends to remain the same, while the nominal interest rate tends to change. After adjusting for inflation an investor should be indifferent to interest rates between the home currency and foreign currency.
What is the international Fischer effect equation?
(1+interest foreign)*(1+change in foreign currency)-1 = interest home.
Hence the change in foreign currency = ((1+interest home)/(1+interest foreign))-1.
This means if interest rates are higher in one country then its currency will depreciate.
Which holds up better? Purchasing power parity or the international Fischer effect?
The international Fischer effect, though the expected inflation = nominal - real is subject to error, and it relies on purchasing power parity, but other factors can also affect the exchange rates, such as government rules or expectations of the future value.
