Sunday, October 02, 2011

Purchasing Power Parity and Interest Rate Parity

CFA Level 1 - Global Economic Analysis

Purchasing Power Parity

Purchasing power parity expresses the idea that a bundle of goods in one country should cost the same in another country after exchange rates are taken into account. Suppose that with existing relative prices and exchange rates, a basket of goods can be purchased for fewer U.S. dollars in Canada than in the United States. We would then expect U.S. consumers to buy those goods in Canada. Even if this is not possible from a transportation or cost viewpoint, some businesses will have an incentive to buy the goods cheaply in Canada and remarket them in the United States. Such actions would cause U.S. dollars to be sold in exchange for Canadian dollars. As a result, the U.S. dollar would depreciate in relation to the Canadian dollar. We would expect the currency depreciation to continue until the bundle of goods costs the same in both countries.

Interest Rate Parity

Interest rate parity has to do with the idea that money should (after adjusting for risk) earn an equal rate of return. Suppose that an investor can earn 6% interest with a dollar deposit in a United States bank, or can earn 4% interest with a British pound deposit in a London bank. The investor can earn greater interest income by keeping funds in dollars and, therefore, one might expect all of his investment funds to flow to U.S. banks. However, exchange rate expectations also come into play. Suppose the investor expects the British pound to appreciate at the rate of 2% in terms of the dollar. That investor would then be indifferent to either investment choice, as both are expected to earn 6%.

Why Central Banks Intervene in the Market

Suppose the United States Federal Reserve is interested in the dollar to euro exchange rate. It can directly influence that exchange rate by buying or selling euros with U.S. dollars. If the Fed buys euros with dollars, it will increase the supply of dollars and decrease the supply of euros. This action tends to cause the U.S. dollar to depreciate in relation to the euro.

A central bank will intervene in the foreign exchange market because it wishes to reduce volatility, and/or it has a specific target exchange rate. Suppose the Fed wants the euro and dollar to trade 1:1, with an allowable range of 2% in either direction. If the exchange rate rose to above 1.02 euros per dollar, the Fed would sell dollars; if the exchange rate fell below .98 euros per dollar, it would buy dollars.
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