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KU ECON 750 - CHAPTER 4 International Parity Conditions- Purchasing Power Parity

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International Financial MarketsOverviewSlide 3Slide 4Slide 5The Usefulness of Parity Conditions in International Financial MarketsSlide 7Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Purchasing Power Parity in a Perfect Capital MarketSlide 15Slide 16Slide 17Slide 18Slide 19Slide 20Slide 21Slide 22Relaxing the Perfect Capital Market AssumptionsEmpirical Evidence on Prices and Exchange RatesSlide 25Slide 26Slide 27Slide 28Quarterly Deviations from Relative PPP CPI: Germany and the United States, 1973-1999Slide 30Slide 31Slide 32Policy Matters - Private EnterprisesSlide 34Policy Matters - Public PolicymakersInternational Parity Conditions: Purchasing Power Parity4 Prices and PoliciesSecond Edition ©2001Richard M. LevichInternational Financial MarketsMcGraw Hill / Irwin4 - 2McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.OverviewThe Usefulness of Parity Conditions in International Financial MarketsAn Overview of International Parity Conditions in a Perfect Capital MarketPurchasing Power Parity in a Perfect Capital MarketThe Law of One PriceAbsolute Purchasing Power ParityRelative Purchasing Power ParityThe Real Exchange Rate and Purchasing Power Parity4 - 3McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.OverviewRelaxing the Perfect Capital Market AssumptionsTransaction CostsTaxesUncertainty4 - 4McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.OverviewEmpirical Evidence on Prices and Exchange RatesEmpirical Methods, or How to Test a Parity ConditionEvidence on the Law of One PriceRelative PPP: Evidence from Recent Quarterly DataRelative PPP: Evidence from Hyperinflationary EconomiesRelative PPP: Evidence from Long-Run DataEmpirical Tests of PPP: Is the Real Exchange Rate Constant?Empirical Tests of PPP: The Final Word4 - 5McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.OverviewPolicy Matters - Private EnterprisesThe Role of Parity Conditions for Management DecisionsPurchasing Power Parity and Managerial DecisionsPurchasing Power Parity and Product Pricing DecisionsPolicy Matters - Public Policymakers4 - 6McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.The Usefulness of Parity Conditionsin International Financial MarketsParity conditions can be thought of as international financial “benchmarks” or “break-even values”.They are the defining points where the decision-maker is indifferent between the two strategies summarized by the two halves of the parity relation.Because parity conditions rely heavily on arbitrage, a violation of parity often implies that a profit opportunity or cost advantage is available to the decision-maker.4 - 7McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.The Usefulness of Parity Conditionsin International Financial MarketsWe begin our analysis of international parity conditions by assuming a perfect capital market (PCM) setting:no transaction costsno taxescomplete certaintyBased on the PCM assumptions, there are four principle parity conditions in international finance, of which only three are independent.4 - 8McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.The Usefulness of Parity Conditionsin International Financial Markets1a. Purchasing Power ParityAbsolute VersionThe price of a market basket of U.S. goods equals the price of a market basket of foreign goods when multiplied by the exchange rate.SpotUKUSPPDriven by arbitrage in goods.4 - 9McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.The Usefulness of Parity Conditionsin International Financial Markets1b. Purchasing Power ParityRelative VersionThe percentage change in the exchange rate equals the percentage change in U.S. goods prices less the percentage change in foreign goods prices.UKUSSpot PP Driven by arbitrage in goods.4 - 10McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.The Usefulness of Parity Conditionsin International Financial Markets2. Interest Rate ParityThe forward exchange rate premium equals (approximately) the U.S. interest rate minus the foreign interest rate. £iiSSF $Driven by arbitrage between the spot and forward exchange rates, and money market interest rates.4 - 11McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.The Usefulness of Parity Conditionsin International Financial Markets3a. Fisher ParitiesFisher Effect (Fisher Closed)For a single economy, the nominal interest rate equals the real interest rate plus the expected rate of inflation. US$$~PEri Driven by desire to insulate the real interest against expected inflation, and arbitrage between real and nominal assets.4 - 12McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.The Usefulness of Parity Conditionsin International Financial Markets3b. Fisher ParitiesInternational Fisher Effect (Fisher Open)For two economies, the U.S. interest rate minus the foreign interest rate equals the expected percentage change in the exchange rate. potS£~$ EiiDriven by arbitrage in bonds denominatedin two currencies.4 - 13McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.The Usefulness of Parity Conditionsin International Financial Markets4. Forward Rate UnbiasedToday’s forward premium (for delivery in n days)equals the expected percentage change in the spot rate (over the next n days).   ttnttttSSSESSF ~Driving force: Market players monitor the difference between today’s forward rate (for delivery in n days) and their expectation of the future spot rate (n days from today).4 - 14McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.Purchasing Power Parityin a Perfect Capital MarketPurchasing power parity (PPP) is built on the notion of arbitrage across goods markets and the Law of One Price.The Law of One Price is the principle that in a PCM setting, homogeneous goods will sell for the same price in two markets, taking into account the exchange rate.£/$wheatUK,wheatUS,SPP 4 - 15McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.Purchasing Power Parityin a Perfect


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