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€)*(Ee$/€ /E$/€)
From UIP to a Theory of Exchange
Rates
• From UIP,
1 + i$ = (1+i€)*(Ee$/€ /E$/€)
we get
E$/€ = Ee$/€ *(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:
Pjeans,$ = Pjeans,€*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?