ECON 101 Lecture Notes - Lecture 7: Purchasing Power Parity, Exchange Rate, Fisher Equation
Economics 101
Lori Leachman
Part 7 • Lecture
• Unholy Trinity of Exchange Rate Theory
o Can only have 2 of the 3:
▪ Fixed Exchange Rate
▪ Capital Mobility
▪ Monetary Autonomy
o Combinations
▪ If you fix and want monetary autonomy, you need capital controls (limit on currency
exchanges, restrictions on foreign ownership, minimum stay requirement for money...etc)
- limit money leaving, keep money stay, reduce money leaving - China
▪ If you want monetary autonomy and capital mobility, you must float - US / EU
▪ If you want fix and capital mobility, must give up monetary autonomy - Mexico,
Thailand, Hong Kong
• Purchasing Power Parity (PPP)
o Exchange rate adjusts to equilibrate the prices on similar goods
▪ P = P* * e or P / P* = e or log P - log P* = log e
▪ Rate of dom P - rate offoreign P = rate ofe
o Ties exchange rate to current account (CA)
o Explains Long Run trends in exchange rate (5-10 years)
o Big mac index gages PPP
o *Trend/Rule
▪ If P > P* (if domestic > foreign): buy foreign goods/services
• FC appreciates, $ depreciates, e increases
• Causes exports to fall (decrease S) and imports to rise (increase D)
▪ If P < P* (if domestic < foreign): buy domestic goods/services
• FC depreciates, $ appreciates, e decreases
• Causes exports to rise (increase S) and imports to fall (decrease D)
o Changes in Prices (P)
▪ Change in inflation
▪ Change in productivity - falling prices
▪ Change in regulation - deregulation leads to falling prices
▪ Change in industrial structure - competition leads to falling prices
▪ Change in innovation - falling prices
• Interest Rate Parity (IRP)
o Ties exchange rate movements to changes in demands for assets due to changing returns (r)
or changing risk; risk-adjusted returns
o Ties exchange rate to FA (Financial account)
o Explains daily, minute-by-minute changes in exchange rate; short run changes (0-2 years)
o IRP dominates over PPP - there is higher volume of money being transferred for assets than for
goods/services
o r* - r = E(e) where r = risk-adjusted return
▪ If r < r* (if higher foreign returns than domestic): buy foreign assets
• FC appreciates, $ depreciates, e increases
• ForA increases (increase D) and Adom decreases (decrease S)
▪ If r > r* (if lower foreign returns than domestic): buy domestic assets
• FC depreciates, $ appreciates, e decreases
• ForA decreases (decreases D) and Adom increases (increases S)
o Changes in Real Return
▪ Change in inflation, no change in interest rate (fisher equation: i = r + p)
• Inflation with no monetary action
▪ Change in interest rate, no change in inflation (fisher equation: i = r + p)
• Monetary action not targeting inflation
find more resources at oneclass.com
find more resources at oneclass.com
Document Summary
Part 7 lecture: unholy trinity of exchange rate theory, can only have 2 of the 3, fixed exchange rate, capital mobility, monetary autonomy, combinations. If you fix and want monetary autonomy, you need capital controls (limit on currency exchanges, restrictions on foreign ownership, minimum stay requirement for moneyetc) Limit money leaving, keep money stay, reduce money leaving - china. If you want monetary autonomy and capital mobility, you must float - us / eu. If you want fix and capital mobility, must give up monetary autonomy - mexico, If p > p* (if domestic > foreign): buy foreign goods/services: fc appreciates, $ depreciates, e increases, causes exports to fall (decrease s) and imports to rise (increase d) Irp dominates over ppp - there is higher volume of money being transferred for assets than for goods/services r* - r = e(e) where r = risk-adjusted return.