fin370part3 - Chap 8 Chapter Objectives - To explain the...

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Chap 8 Chapter Objectives - To explain the purchasing power parity PPP and international Fisher effect IFE theories and their implications for exchange rate changes; and - To compare the PPP, IFE, and interest rate parity IRP theories Interpretations of PPP - The absolute form of PPP is an extension of the law of one price. It suggests that the prices of the same products in different countries should be equal when measured in a common currency. - The relative form of PPP accounts for market imperfections like transportation costs, tariffs, and quotas, It states that the rate of price changes should be similar Rationale Behind PPP Theory Suppose U.S. inflation > UK inflation Increase U.S. imports from U.K. and Decrease U.S. exports to U.K. Upward pressure is placed on the Pound This shift in consumption and the pounds appreciation will continue until 1) in the US price(uK goods) >= price (us goods) 2) in the UK price(us goods) <= price (uk goods) Derivation of PPP Assume that PPP holds. Over time, inflation occurs and the exchange rate adjusts to maintain PPP.
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fin370part3 - Chap 8 Chapter Objectives - To explain the...

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