FIN 476

1. FIN 476 Parity Conditions

2. Parity Conditions • Parity Conditions: formalization of the relationship between • Exchange rate s and fundamental economics variables • Two important parity relationships to look at right now: • Purchasing Power Parity: relationship between • inflation and exchange rate 2. International Fisher Effect: relationship between interest rates and exchange rate

3. Purchasing Power Parity(PPP) • Two versions: (a) Absolute PPP [old version] • (b) Relative PPP [modern version] • Absolute PPP • based on law of one price • things should cost the same no matter where you buy them

4. Absolute Version of PPP • Example: Big Mac Index • cost of a Big Mac at McDonald’s Restaurants • throughout world

5. absolute PPP does not hold empirically • Relative PPP • version that is commonly used to forecast exchange rates • absolute levels of prices may differ between countries • relative price levels should remain constant • Let exchange rate, e, be in terms of units of • domestic currency per unit of foreign currency

6. PPP and Competitive Position • if relative PPP holds, then the competitive position of • countries does not change • PPP says that exchange rates change to offset differences • in inflation rates • Important Question: Does PPP hold empirically?

7. International Fisher Effect(IFE) • IFE gives a relationship between interest rates and the • exchange rate • based on nominal interest rates • if real rates are equal across countries, then IFE is simply a • restatement of PPP • Let exchange rate, e, be in terms of units of • domestic currency per unit of foreign currency

8. IFE • Intuition: exchange rates and interest rates adjust so that • investors expect to make the same return in both countries • this assumes equal risk (equal real rates) in the • two countries • would have to adjust for this in practice

9. IFE (cont.) • Because IFE is based on investors’ expectations of changes • in exchange rate, it really concerns long term interest rates