ECON 311 1nd Edition Lecture 10 Outline of Last Lecture I. The Term Structure of Interest RatesII. Bond Investing StrategyIII. Yield Curves and Expected InflationOutline of Current Lecture I. Purchasing Power ParityCurrent LectureI. Purchasing Power Paritya. Application of the law of one price to foreign exchange marketsi. A dollar should have some purchasing power everywhereii. Value of $1 in the US = Value of $1 in a foreign countryE = nominal exchange rate (foreign currency/ US $)P = US price levelP* = Foreign Price LevelValue of $1 in US = 1/PValue of $1 in a Foreign Country = E/P* so:% ∆ E =% ∆ P¿−% ∆ PWhere P* is the foreign inflation rate and P is the US inflation rateSuppose the US inflation rate is 3% and the Mexican inflation rate is 5%The US dollar will depreciate by 2% relative to the pesoDifference in inflation rates causes the fluctuation in exchange ratesBig Mac Index (comparing Big Mac prices globally)Price of Big Mac = 32 pesos/big macThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.Price of Big Mac = $3/big macSo Exchange rate = 32 pesos/$3 = 10.67 pesos/$1If this is the actual exchange rate the US dollar is over valued and will depreciate in the long runPurchasing Power Parity Implications:In the Long Run:1. Relative Price Levelsa. If P increases, E decreases2. Trade Barriersa. If US trade barriers increase, E increases3. Relative Preferences for Foreign and Domestic Goods4. Relative Productivitya. If US productivity increases, E increasesThis works in the long run but NOT the short