Prices, Interest Rates, and Exchange Rates in Equilibrium

Fisher effect

Nominal interest rates are the required real rate of return (r) plus expected inflation

International fisher effect

the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries

Interest rate parity

The difference in the national interest rates should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency (except for transaction costs)

Forward rate as an unbiased predictor

the forward rate is an efficient predictor of the future spot rate

Impossible Trinity

Full financial integration

Exchange rate stability

Monetary Independence

fixed (pegged to somthing)

hard peg (currency board / dollarization)

soft peg

floating (market driven)

managed float

free floatc

crawling peg

currency adjusted in small amounts at a fixed rate

balance of payments

all international transactions between foreigns and residents of a country

BOP account: Current subaccounts

import and export of g/s

transfers

income (investment and wages)

BOP account: capital subaccounts

direct investment

portfolio investment

other investment assets/liabilities

absolute PPP

spot exchange rate determined by the relative prices of a similar basket of goods

relative PPP

Any change in the differential rate of inflation b/w 2 countries is usually offset by an equal but opposite change in the spot rate

empirical tests of PPP

not very accurate in predicting future exchange rates

holds better for developing countries with high inflation

good for long-term rather than short term