Chap06 addendum PPP

Chap06 addendum PPP - InternationalParity Relationships...

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01/18/10 The Parity Conditions - PPP 1 International Parity  Relationships Chapter 6 Focusing on Purchasing Power Parity Eun & Resnick, pp 142-149
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01/18/10 The Parity Conditions - PPP 2 Exchange Rate Theories The Parity relations determine how interest rates, exchange rates and inflation are related across countries. 1) The exchange rate between the home currency and any foreign currency will adjust to reflect changes in the price levels of the two countries (purchasing power parity – PPP). 2) The difference in interest rates between countries will reflect differences in inflation rates (Fisher effect -- FE). 3) Combining the Fisher effect and purchasing power parity results in the concept that a rise in the home country’s inflation rate will be associated with a fall in the home currency’s value. It will also be associated with a rise in the home interest rate relative to foreign interest rates (international Fisher effect – IFE).
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01/18/10 The Parity Conditions - PPP 3 Exchange Rate Theories 4) The difference in interest rates between two countries should equal the forward premium or discount (interest rate parity -- IRP) 5) The forward rate is an unbiased predictor of the future spot rate (forward expectations parity (FEP) and therefore the forward exchange premium or discount will be equal to the expected inflation rate differential (FPPP) .
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01/18/10 The Parity Conditions - PPP 4 Approximate Equilibrium Exchange  Rate Relationships  ($/foreign currency) E ( π $ π £ ) ≈ IRP ≈ PPP ≈ FE ≈ FRPPP ≈ IFE ≈ FEP S F S E ( e ) ( i $ i ¥ )
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01/18/10 The Parity Conditions - PPP 5 Purchasing Power Parity Spot exchange rates between currencies will change to the differential in inflation rates between countries Absolute Form: Price levels adjusted for exchange rates should be equal between countries One unit of currency has same purchasing power globally. The exchange rate between 2 countries should equal the ratio of the countries’ price levels. S($/¥) = P $ / P ¥ Relative Form: The exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries.
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01/18/10 The Parity Conditions - PPP 6 Purchasing Power Parity The Big Mac Index – Based on Absolute Form of PPP http://www.economist.com/markets/Bigmac/Index.cfm Burgernomics is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean
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Chap06 addendum PPP - InternationalParity Relationships...

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