Recap: UIP, PPP, and Exchange Rates

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Presentation transcript:

Recap: UIP, PPP, and Exchange Rates Roberto Chang February 2013

Admistrative First homework due today. Please make sure to give it to me by the end of class. Next Monday: No Class.

Covered Interest Parity A consequence of arbitrage It provides a link between interest rates, the spot exchange rate, and the forward exchange rate: 1 + i$ = (1+i€)*(F$/€ /E$/€)

Uncovered Interest Parity Based on the assumption that investors care only about expected returns Gives a link between interest rates, the spot exchange rate, and the expected future exchange rate: 1 + i$ = (1+i€)*(Ee$/€ /E$/€)

From UIP to a Theory of Exchange Rates 1 + i$ = (1+i€)*(Ee$/€ /E$/€) we get E$/€ = Ee$/€ *(1 + i$ )/ (1+i€) This says that we understand the current exchange rate if we understand interest rates and the expected future exchange rate.

Pjeans,$ = Pjeans,€*E$/€ Law of One Price The LOOP says that a particular good must sell at the same price in different locations, when the price is quoted in a common currency: Pjeans,$ = Pjeans,€*E$/€

Purchasing Power Parity PPP is like LOOP but applied to baskets of goods and services (i.e. the typical consumer basket): P$ = P€*E$/€ The price of the said baskets is usually what we mean by the price level. PPP is a reasonable assumption about the long run

From PPP to Long Run Exchange Rates P$ = P€*E$/€ one gets E$/€ = P$/ P€ Hence the (long run) exchange rate is given by the (long run) ratio of price levels. Next question: what determines price levels?