536-2.1a_note[1]

536-2.1a_note[1] - 536-2.1a_note, 11S Topic 2.1...

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536-2.1a_note, 11S FIN 536 – SU Page 1 of 8 Topic 2.1 International Parity Conditions (Chapter 7) Purchase Power Parity (PPP) I. Outline A. Introduction: 1. Inflation 2. Nominal vs. Real FX B. Parity Condition 1. PPP 2. FE 3. IFE 4. IRP 5. UFH II. Homework Assignment Chapter End-of-Chapter Question 1, 5 End-of-Chapter Problem (P) 1-6, 16, 19 Exam Sample Problem (ES) 1-8 Supplementary Homework Problem (SH) 1-7 ========================================================= Class Notes I. Introduction: A. The Monetary theory of Inflation: 1. What causes inflation? When the expansion of the money supply exceeds real output growth ==> Inflation (loss of purchasing power) 2. How to calculate inflation rates? π = % P 3. Example: Time = 0, CPI = 100. Time = 1, CPI = 103. Time = 2, CPI = 109. What is π ? 0 1 2
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536-2.1a_note, 11S FIN 536 – SU Page 2 of 8 B. Nominal Exchange Rate C. Real exchange rate (Ex. 7.3) 1. Nominal exchange rate adjusted by inflation rate 2. Real Exchange Rate Example 1: In 2007, S = 1.25 $/€. In 2008, S = 1.32 $/€. In 2008, the inflation rate is 4% in US and 1% in Euro land. What is the real exchange rate? a) Use 2007 as the base year, what is the real exchange rate in 2007 (S * )? b) What is the real exchange rate in 2008? 3. Real Exchange Rate Example 2: In 2007, S = 1.3161 SF/$. In 2008, S = 1.2197 SF/$. In 2008, the inflation rate is 4% in US and 2% in Switzerland. What is the real exchange rate? a) Use 2007 as the base year, what is the real exchange rate in 2007 (S * )? b) What is the real exchange rate in 2008? II. Diagram of Parity Relationships Law of one price Arbitrage Expected Exchange rate change 1.PPP 5.UFR 2.FE 3.IFE Relative excess money supply 4.IRP Relative interest rate Relative inflation rate Forward premium or discount 0 1 0 1
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536-2.1a_note, 11S
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536-2.1a_note[1] - 536-2.1a_note, 11S Topic 2.1...

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