Exchange rates and purchasing power parity

6 important questions on Exchange rates and purchasing power parity

Purchasing power parity states

The nominal exchange rate will adjust so tht the purchasing power of a currency will be the same in every country e(Pus/PM)=1

(dis)advantages Floating exchange rates

-+ equilibrium BoP
-+adjustments
-- uncertainty

(dis)advantages Fixed exchange rates

-+facilitates trade
-+ anchor
--misalignment
--speculation
--no monetary policy
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Calculate the real effective exchange rate for the following information:
nominal exchange rate ($/€) is = 1.50; domestic price level
(EU) index is
150, foreign price level index is 1.2.


Real xr:1.50*(150/120) = 1.87 US perspective (see
-
241) for a definition of real exchange rateas the rate at which goods trade against eachother)
•EU perspective?
•€/$ = 0.67
•Realxr
: 0.67*(120/150) = 0.54 (1/0.54 = 1.85 {almost 1.87})

Given exchange rates: USD/GBP = 2; USD/EUR =0,76; EUR/GBP = 2,58.
How can you make money from this? Give all transactions. What will happen
if many follow your strategy?


$/Pd= 2; $/€= 0.76; €/Pd 2.58
•100 $ -> 50 Pd-> 129 €-> 98.04 $ (no!)
•100 €-> 131.6€-> 51 Pd-> 102 $ (yes!)

Suppose the spot rate GBP equals $2.00, while the 3 month forward rate
equals $1.99. British 3 month paper goes at 12 per cent (annualized),
American 3 month paper goes at 6 per cent (annualized). How can you make
money from this? Give all transactions. What will happen if many follo
w your
strategy?


•Spot $/Pd= 2; 3 mthforward $/Pd= 1.99
•GB interest rate 12 %/yr; US interest rate 6%/yr
•100 $ in US -> 100*(1.015) = 1.015 $ after 3 month
•100 $ -> 50 Pd-> 50*(1.03) = 51.5 Pdafter 3 month -> 51.5*1.99 = 102.5 $

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