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Recap : UIP, PPP, and Exchange Rates

Recap : UIP, PPP, and Exchange Rates. Roberto Chang February 2012. 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 $/€ ).

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Recap : UIP, PPP, and Exchange Rates

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

  2. CoveredInterestParity • A consequence of arbitrage • Itprovides a link betweeninterestrates, the spot exchangerate, and theforward exchangerate: 1 + i$= (1+i€)*(F$/€ /E$/€)

  3. UncoveredInterestParity • Basedontheassumptionthatinvestorscareonlyaboutexpectedreturns • Gives a link betweeninterestrates, the spot exchangerate, and theexpectedfutureexchangerate: 1 + i$= (1+i€)*(Ee$/€ /E$/€)

  4. From UIP to a Theory of Exchange Rates • From UIP, 1 + i$= (1+i€)*(Ee$/€ /E$/€) weget E$/€ = Ee$/€ *(1 + i$ )/ (1+i€) • Thissaysthatweunderstandthecurrentexchangerateifweunderstandinterestratesand theexpectedfutureexchangerate.

  5. Law of One Price • The LOOP saysthat a particular goodmustsell at thesameprice in differentlocations, whenthepriceisquoted in a commoncurrency: Pjeans,$ = Pjeans,€*E$/€

  6. PurchasingPowerParity • PPP islike LOOP butappliedtobaskets of goods and services (i.e. thetypicalconsumerbasket): P$ = P€*E$/€ • Theprice of thesaidbasketsisusuallywhatwe mean bythepricelevel. • PPP is a reasonableassumptionaboutthelongrun

  7. From PPP to Long Run Exchange Rates • From PPP, P$ = P€*E$/€ onegets E$/€ = P$/ P€ • Hencethe (longrun) exchangerateisgivenbythe (longrun) ratio of pricelevels. • Nextquestion: what determines pricelevels?

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