1. Recap: UIP, PPP, and Exchange Rates Roberto Chang February 2012

2. 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 $/€ )

3. 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 € )*(E e $/€ /E $/€ )

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

5. 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: P jeans,$ = P jeans,€ *E $/€

6. 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

7. From PPP to Long Run Exchange Rates From PPP, 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?