Chapter 4 Parity conditions and currency forecasting.
Use graphs and examples where relevant.
a What is purchasing Power Parity (PPP)?
b What are some reasons for the deviations from PPP?
c Under what circumstances can PPP be applied?
One proposal to stabilise the international monetary system involves setting exchange rates at their PPP rates. Once exchange rates are correctly aligned (according to PPP), each nation would adjust its monetary policy so as to maintain them. What problems might arise from using the PPP rate as a guide to the equilibrium exchang
Current understanding of the workings of the foreign exchange market suggests that in the absence of government intervention in the market, both the spot rate and the forward rate are influenced heavily by current expectations of future events. The two rates move in tandem, with the link between them based on interest differentials. New information, such as a change in interest rate differentials, is reflected almost immediately in both spot and forward rates.
Explain this understanding using, a graph illustrating the Parity line and the relationship between the forward rate and the future spot rate.
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