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Chap06 part 3

# Chap06 part 3 - Chapter 6 Part 3 Tying all 5 parity...

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01/18/10 The Parity Conditions - Part 3 1 International Parity Relations Chapter 6 Part 3 – Tying all 5 parity relations together…

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01/18/10 The Parity Conditions - Part 3 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).
01/18/10 The Parity Conditions - Part 3 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 - Part 3 4 Approximate Equilibrium Exchange  Rate Relations  (\$/foreign currency) Ex. 6.9 p. 152 E ( π \$ π £ ) ≈ IRP ≈ PPP ≈ FE ≈ FPPP ≈ IFE ≈ FEP S F S E ( e ) ( i \$ i ¥ ) E(e) = expected change in spot rate π = inflation rate i = interest rate
Note to Exhibit 6.9 1. With the assumption of the same real interest, the Fisher effect (FE) implies that the interest rate differential

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Chap06 part 3 - Chapter 6 Part 3 Tying all 5 parity...

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