The nominal exchange rate

Appreciation of the RER

An increase in purchasing power of the domestic currency (Q decreases)

PPP and RER

Even if not equal to 1, the RER should be at a level compatible with equilibrium in the economy. Each RER level is associated to a trade balance value. The equilibrium RER depends on variables that affect the equilibrium level of the CA or that affect the relationship between the RER and the CA: (the productivity in tradable and non-tradable sectors, the terms of trade, government expenditure, the level of indebtedness of a country, among others.)

Risk premium

Even if there is perfect mobility of capital, there can be differences in return between assets if they are not perfect substitutes. The differences in their return reflect differences in their relative attractiveness. For instance: differences in risk Credit risk evaluation agencies, such as Standard & Poor's and Moody's, attribute credit risk ratings to countries, companies and banks. Countries with a higher credit risk should supply a higher yield on their assets to compensate investors for the risk incurred. The term risk premium refers to this increase in return associated with the ability to pay of the issuer of the asset.

The purchasing power parity

If the price index is calculated in exactly the same way in the countries, and if there are no international trade costs for any good, the purchasing power of the currency in both countries should be identical. This condition is known as Absolute Purchasing Power Parity (Absolute PPP), described as

Uncovered interest rate parity

If there is no exchange rate risk premium, we have that:

The law of one price

If there were neither transportation costs nor any trade barriers, the price of a good should be the same in both countries, when measured in the same currency.

Interest rate parity conditions

If, however, the German and American assets in question neither differ in relation to risk nor liquidity, the only difference between them is their return. With free capital mobility, a difference in the assets returns will lead investors to allocate all available wealth to invest in the asset with the higher return. Hence, the non-arbitrage condition implies the same return for German and American assets:

Carry trade

In practice, data reveals relatively persistent deviations in interest parity. gains from carry trade: contract debt in a country where the interest rate is low and invest in assets where the return is higher Why is this not done until those gains are exhausted, as the theory proposes? A possible answer: the possibility of an abrupt depreciation in the country where resources are invested, causing large losses

Uncovered interest rate parity

Investors may opt to arbiter between the return of two assets without resorting to the future exchange market. In this case, the non-arbitrage condition is uncovered interest rate parity condition:

ER depreciation

Or a depreciation of the domestic currency. An increase in the price of foreign currency=the domestic currency is worth less

ER appreciation

Or an appreciation of domestic currency. A reduction in the price of foreign currency=the domestic currency is worth more

Big Mac Index

Price in dollar= Pb/S

Relative PPP

RER is at its equilibrium level, and the variables that determine this level do not vary: relative purchasing power parity (Relative PPP)

Covered interest parity condition

Reorganizing the previous equation, we have the rate parity condition For an investor, it is not the ER that matters, but its variation over time. An ER change between the time of buying and selling a foreign asset alters the value of the foreign asset in domestic currency. Two crucial assumptions: free capital mobility and perfect substitutability of assets.

How is the Nominal exchange rate determined ?

Supply and demand of foreign currency Registers in the balance of payments - credits= supply of foreign policy - debits= demand for foreign currency

The exchange rate

The ER is the price relative to two currencies. We usually quote the ER as the price of the foreign currency in terms of the domestic currency

Interest rate parity conditions

The difference in returns between the two assets, 𝐷𝐼𝐹𝐹, is therefore: The return differential is one of the criteria used by investors to decide which asset to purchase. The American and German assets can also differ in relation to their liquidity or the risk associated with them The higher the relative return of the American asset, the higher its attractiveness will be in relation to the German, and, consequently, the higher its demand will be.

Nominal exchange rate

The price for foreign currency. Relevant to all those who trade goods, financial assets, or services with other countries.

Depreciation of the RER

The purchasing power of the domestic currency decreases (Q increases)

The real exchange rate

The real exchange rate measures the relative price of goods between the two countries. Q= Real exchange rate S= rate P= Price

Why is PPP not valid ?

Transportation costs Non-tradables goods Diferentiated goods Differences in preferences