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

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

3. 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$/€ /E$/€)

4. 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$/€ /E$/€)

5. 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.

6. 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$/€

7. 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

8. 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?