Arbitrage Facts &
This!!
Figures
Credits
& Debits
Model
Behavior
Potpourri
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Final Jeopardy
$100 Arbitrage This!!
PPP implies that if inflation in the
US is 4% while inflation in Europe
is 2%, this should happen.
The dollar should depreciate by 2%
against the Euro.
*
% e    
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$200 Arbitrage This!!
Suppose that the dollar is expected
to depreciate. UIP suggests that
this should happen to US interest
rates
They should increase by the expected
percentage change in the exchange
rate
i  i  %e
*
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$300 Arbitrage This!!
UIP combined with PPP suggests
this about inflation adjusted
interest rates.
Real (inflation adjusted) interest rates
should be equalized across countries.
i  i *  %e     *
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$400 Arbitrage This!!
Consider the
following
exchange rates
EUR/USD = $1.50
JPY/USD = $ .001
JPY/EUR = E .002
You could make money by doing this.
Use Yen to buy Euros (the Euro is undervalued),
use Euros to buy $ (the Euro is overvalued
relative to $)
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$500 Arbitrage This!!
Suppose that Americans spend 80% of
their income on services while
Europeans spend 50% on services. A
10% worldwide increase in the cost of
services would do this
The US would experience a real
appreciation of 3% against the Euro
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$500 Arbitrage This!!
For Simplicity, assume that all prices are initially 1.
*
*
Pservices  Pother  Pservices
 Pother
1
P  P*  1
e  RER  1
The following year we have the following.
Pservices  $1.10, Pother  $1.00
*
*
Pservices
 E1.10, Pother
 R1.00
P  (.8)($ 1.10)  (.2)($ 1.00)  $1.08
P *  (.5)( E1.10)  (.5)( E1.00)  R1.05
eP * 1(1.05)
RER 

 .97
P
1.08
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Facts & Figures $100
For most of the modern era,
international financial markets
have operated under this standard
The Gold Standard
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Facts & Figures $200
Trade in these “garage sale” assets
dominates currency markets
Swaps
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Facts & Figures $300
$2 Billion dollars per day is
roughly the size of this
US Trade Deficit
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Facts & Figures $400
This pair of financial economists
revolutionized the field of option pricing
Fischer Black and Myron Scholes
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Facts & Figures $500
The Euro is currently selling for
$1.28. If Eurozone interest rates are
4% while US interest rates are 3%,
this should be the price of a 1 year
Euro forward contract
$1.267
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Credits and Debits $100
US investors currently hold over
$1T in foreign investments. Interest
paid on these assets would show up
as this in the current account
A credit (+) in Net Factor Payments (Income
earned abroad)
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Credits and Debits $200
A positive entry in the
financial account refers to
this
Capital Inflow
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Credits & Debits $300
There has been talk of the Fed stepping in to
increase the value of the dollar. This
transaction would be recorded in this section
of the BOP
US Official Reserve Assets
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Daily Double: Debits & Credits
An American MNC acquires a foreign subsidiary.
This transaction would look like this in the BOP
(Two entries)
(+) Foreign Acquisition of US Private Assets
(-) FDI
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Credits and Debits $500
US Aid to developing
countries shows up like this
in the BOP
A debit (-) in Net Unilateral
Transfers
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Model Behavior $100
In the monetary model with
flexible prices, this market
takes center stage.
Money Market (Commodity Market)
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Model Behavior $200
The portfolio balance model can be
distinguished from other exchange
rate models by this unique feature
PPP and UIP do not hold
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Model Behavior $300
A 10% contraction of the US money
supply would result in this if
commodity prices are fully flexible
A 10% dollar appreciation
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Model Behavior $400
If commodity prices are fixed and
capital is perfectly mobile, a 5%
increase in the US money supply
would cause this in the short run.
A depreciation (both real and nominal) of
more than 5%
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Model Behavior $500
Currency prices tend to be extremely
volatile. According to the monetary
approach with flexible prices, this
volatility is a result of this
Relative price changes
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Potpourri $100
This name could refer to an economic
curve describing the relationship
between exchange rates and trade
balances or the sidekick to a pudgy,
silent, stoner
Jay
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Potpourri $200
A Nobel Laureate was the topic of
this 2001 Oscar winner
A Beautiful Mind
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Potpourri $300
If trade balances are all that matter for
currency prices, then this is the source of
volatility in currency markets
Low demand/supply elasticity
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Potpourri $400
If the elasticity of imports for the US is
3, this would need to happen to
generate a 10% decline in US import
expenditures.
A 5% nominal depreciation
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Potpourri $500
The necessary conditions for the
J-Curve were developed by this
pair of economists
Marshall and Lerner
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Any general equilibrium
model
of exchange rates should
contain interactions
between these
five markets
Final Jeopardy
Home money market
Foreign money market
Home bond market
Foreign bond market
Currency market