# Recap: UIP, PPP, and Exchange Rates Roberto Chang February 2012.

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Recap: UIP, PPP, and Exchange Rates Roberto Chang February 2012

Covered Interest Parity A consequence of arbitrage It provides a link between interest rates, the spot exchange rate, and the forward exchange rate: 1 + i \$ = (1+i € )*(F \$/€ /E \$/€ )

Uncovered Interest Parity Based on the assumption that investors care only about expected returns Gives a link between interest rates, the spot exchange rate, and the expected future exchange rate: 1 + i \$ = (1+i € )*(E e \$/€ /E \$/€ )

From UIP to a Theory of Exchange Rates From UIP, 1 + i \$ = (1+i € )*(E e \$/€ /E \$/€ ) we get E \$/€ = E e \$/€ *(1 + i \$ )/ (1+i € ) This says that we understand the current exchange rate if we understand interest rates and the expected future exchange rate.

Law of One Price The LOOP says that a particular good must sell at the same price in different locations, when the price is quoted in a common currency: P jeans,\$ = P jeans,€ *E \$/€

Purchasing Power Parity PPP is like LOOP but applied to baskets of goods and services (i.e. the typical consumer basket): P \$ = P € *E \$/€ The price of the said baskets is usually what we mean by the price level. PPP is a reasonable assumption about the long run

From PPP to Long Run Exchange Rates From PPP, P \$ = P € *E \$/€ one gets E \$/€ = P \$ / P € Hence the (long run) exchange rate is given by the (long run) ratio of price levels. Next question: what determines price levels?

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