Chapter5Models of theforeignexchangedetermination
Chapter 5 Models of the foreign exchange determination
5.1PurchasingpowerparityThe theory linking inflation and exchangerate movements is knownaspurchasingpowerparity (PPP)
5.1 Purchasing power parity The theory linking inflation and exchange rate movements is known as purchasing power parity (PPP)
ThelawofonepriceoThetheoryofPPpisbasedonthelawofoneprice (LOP).The law of one price states that identicalcommodities or goods must have the sameprice in all markets
The law of one price The theory of PPP is based on the law of one price (LOP). The law of one price states that identical commodities or goods must have the same price in all markets
Absolute andrelativePPPPGBp(O) = Pusp(O)S。(GBP / USD)This relation represents the absolute form ofPPP andis veryrestrictive
Absolute and relative PPP 0 (0) (0) ( / ) P P S GBP USD GBP USD = This relation represents the absolute form of PPP and is very restrictive
R(0)S,(GBP / USD)PusD (t)S.(GBP / USD)(0)TherelativeformofPPP,morecommonlyused today,is less restrictive than theabsoluteform.o Itstatesthat incomparisonto aperiodwhenexchangerateswereineguilibriumchangesintheratioof domesticto foreignprices indicatethe appropriate adjustmentin the exchangerate
0 ( ) ( / ) (0) ( / ) ( ) (0) GBP t GBP USD USD P t S GBP USD P S GBP USD P t P = The relative form of PPP, more commonly used today, is less restrictive than the absolute form. It states that in comparison to a period when exchange rates were in equilibrium, changes in the ratio of domestic to foreign prices indicate the appropriate adjustment in the exchange rate
Theempirical evidenceoWhetherornotPPpholdsisanongoingcontroversy.Thereasonswhyitmightnothold are numerous.oThe strictest formof PPP reguiresthat:--financial marketsareperfectwithno controls,taxes,transactioncosts,etc;--goodsmarketsareperfectwithinternational shipmentofgoodsabletotakeplacefreely,instantaneouslyandwithout cost;--thereis a single consumptiongood commontoeveryone;--thesamecommoditiesappearinthesameproportions in each country's consumption basket
The empirical evidence Whether or not PPP holds is an ongoing controversy. The reasons why it might not hold are numerous. The strictest form of PPP requires that: - financial markets are perfect with no controls, taxes, transaction costs, etc; - goods markets are perfect with international shipment of goods able to take place freely, instantaneously and without cost; - there is a single consumption good common to everyone; - the same commodities appear in the same proportions in each country’s consumption basket
Reasons for divergence from short-term PPPoTheassetmarketapproachoOvershootingoTheportfoliobalanceapproach
Reasons for divergence from short-term PPP The asset market approach Overshooting The portfolio balance approach
5.2CoveredinterestparityBackgroundTheClPconditiono Consider an investorwho has initial capital,K, and faces two alternatives:(i)domesticinvestment,wherebytheinvestorbuysdomesticassets,earningthedomesticinterestrate,i(ii)foreigninvestment,wherebytheinvestorconvertsthedomesticcurrencyintoforeigncurrencytobuyforeignassets,earningtheforeigninterestrate,i*
5.2 Covered interest parity Background The CIP condition Consider an investor who has initial capital, K, and faces two alternatives: (i) domestic investment, whereby the investor buys domestic assets, earning the domestic interest rate, i; (ii) foreign investment, whereby the investor converts the domestic currency into foreign currency to buy foreign assets, earning the foreign interest rate, i*
The mechanics of covered arbitrageArbitragefromthedomesticcurrencytoaforeign currencyF(1+i*)-(1+i)元三Sorapproximatelyπ=i*-i+f
The mechanics of covered arbitrage Arbitrage from the domestic currency to a foreign currency (1 ) (1 ) F i i S = + − + i i f = − + or approximately
oArbitragefromaforeigncurrencytothedomesticcurrencyS(1+i)-(l+i*)元二Forapproximatelyπ=i-i-Theno-arbitrageconditionF
The no-arbitrage condition 1 [ ] 1 i F S i + = + Arbitrage from a foreign currency to the domestic currency or approximately (1 ) (1 ) S i i F = + − + i i f = − −