Global Economic Analysis - Purchasing Power Parity and Interest Rate Parity
Purchasing Power Parity
Purchasing power parity expresses the idea that a bundle of goods in one country should cost the same in another country after exchange rates are taken into account. Suppose that with existing relative prices and exchange rates, a basket of goods can be purchased for fewer U.S. dollars in
Interest Rate Parity
Interest rate parity has to do with the idea that money should (after adjusting for risk) earn an equal rate of return. Suppose that an investor can earn 6% interest with a dollar deposit in a United States bank, or can earn 4% interest with a British pound deposit in a London bank. The investor can earn greater interest income by keeping funds in dollars and, therefore, one might expect all of his investment funds to flow to
Why Central Banks Intervene in the Market
Suppose the United States Federal Reserve is interested in the dollar to euro exchange rate. It can directly influence that exchange rate by buying or selling euros with U.S. dollars. If the Fed buys euros with dollars, it will increase the supply of dollars and decrease the supply of euros. This action tends to cause the U.S. dollar to depreciate in relation to the euro.
A central bank will intervene in the foreign exchange market because it wishes to reduce volatility, and/or it has a specific target exchange rate. Suppose the Fed wants the euro and dollar to trade 1:1, with an allowable range of 2% in either direction. If the exchange rate rose to above 1.02 euros per dollar, the Fed would sell dollars; if the exchange rate fell below .98 euros per dollar, it would buy dollars.