## Summary

## Assumptions

- With no intervention ΔR=0 thus ΔM=DCE
- Four way equivalence theorem
- Purchasing power parity
- In all three case the assumption is spot rate of excahnge at any date is underpinned by relative price levels in the two countries

- International Fisher Effect
- Assumption of capital is mobile expected real rates of return should be equal

- Purchasing power parity

## Model/Theory

Four way equivalence theorem

- Purchasing power parity -
- explained by
- aggregate price determination where you fix exchange rates to determine domestic money prices and fix reserves to predict exchange rate where equilibriums are both governed by PPP. where e=P/P*=(M/ky)/(M*/ky*)
- Goods arbitrage but problems include 1. not all goods are traded 2. barriers to trade exist 3. not all commodities exhibit a high degree of substitutability. Further difficulty is why e rather than P adjusts.
- Demand for foreign exchange to buy imports (Z) = Supply from the resulting exports (X)

- explained by
- International Fisher effect
- Differences in nominal interest rates = differences in expected inflation.

- Interest rate parity
- US exporter till receive £X at t=1
- Could either do a forward foreign transaction f_0.X
- Or borrow a loan, convert at spot and invest in US money market for X/(1+i_£).s_0(1+i_$)
- These equate and simplify to the interest rate parity relationship.

- Expectations theory of exchange rates
- Says that expected spot rate = unbiased predictor of the future spot rate.

- Fisher open hypothesis

## Predictions

Four way equivalence theorem

- Expected change in spot = Difference in expected inflation

## Evidence

Only the covered interest rate parity holds all the time.

## Evaluation

Two scenarios when a closed economy model is appropriate:

- Unified world economy employing a uniform currency or its close approximation fixed exchange rates pegs under the IMF from 1945 to 1971
- National currency to be linked to other currencies by a completely flexible exchange rates.

Four-way equivalence theorem - equilibrium but don't necessarily hold all the time.

- Purchasing power parity
- Problems include 1. not all goods are traded 2. barriers to trade exist 3. not all commodities exhibit a high degree of subsitutability
- Further difficulty is why e rather than P adjusts.

- Expectations
- However, this assumes an absence of risk Thus the unbiased forward rate condition may not hold.