Global Economic Analysis -

Introduction
Now that we have discussed everything you need to know regarding micro and
macroeconomics, let's broaden the scope to also include international trade, foreign
exchange and the balance of payments.

Understanding how one country's economy and government reacts with other countries'
economic activity is important because it helps analysts to determine the strength of
economies around the world, as well as exchange rate movement.

TRADING WITH THE WORLD

A nation can gain from international trade when:

 Its relative costs of producing various goods differ from other nations
 It specializes in producing goods in which the nation is relatively efficient at
producing and uses the proceeds from its output to produce goods for which it is
relatively inefficient.

Note that these costs are relative to a country's opportunity costs. A country could have an
absolute advantage in producing (able to produce more) over another country for all goods
and still benefit from trade. How nations trade is determined by their comparative
advantages.

Benefits of trade include:

 Better Quality of Goods - Domestic producers are forced to maintain and/or improve
quality due to competition from foreign producers.
 Lower Prices Due to Economies of Scale - Because producers have larger potential
markets due to international trade, they can sometimes achieve lower per-unit costs
with large-scale production. Consumers benefit by being able to purchase the lower-
priced goods. Manufacturers often benefit by being able to purchase parts at lower
costs.
 Better Institutions and Government Policies - Global trade gives government
policymakers incentive to create constructive economic policy. A failure to do so,
however, will cause capital and labor to flow elsewhere

Production Possibility Curves

To illustrate the benefits of trade, we should look at the production possibility curves for two
nations, Great Britain and the U.S. The production possibility curve (or production possibility
frontier) shows the maximum possible output of an economy. To simplify things, we will
assume that only two goods are produced - wheat and steel.

Figure 5.1: Production Possibility Curves

According to the production possibilities curve shown in the above graphs, the U.S. could
produce 50 units of wheat per worker, if it devoted all of its resources to wheat production,
and zero units of steel. If all resources were devoted to producing steel, then the U.S. would
have 50 units of steel per worker and no wheat. If Great Britain devotes all of its resources
to making wheat, it can produce 20 units of wheat, with no steel being produced. If that
country concentrates all of its resources on producing steel, then 40 units of steel would be
produced per worker, with no wheat production. Please note that the U.S. has an absolute
advantage over Great Britain with both products because the U.S. workers are more
productive than those from Great Britain. However, this is not important from an
international trade perspective.

The domestic exchange rate within the U.S. for the two goods is 1:1; for each unit of steel
produced, the U.S. must give up producing one unit of wheat. We could say that the cost of
one unit of steel within the U.S., assuming no international trade, would be one unit of
wheat. Similarly, the cost of one unit of wheat would be the loss of one unit of steel.

Great Britain would have a different domestic exchange rate. Its production possibility curve
implies that the cost of one unit of steel would be one-half of a unit of wheat. The cost of
one unit of wheat would be two units of steel. These costs can be obtained by looking at the
slope of the production possibility curve.

If the U.S. and Great Britain both operated as autarkies (self-sufficient nations that do not
trade), then each country would operate somewhere on their production possibilities curve.
The exact point of production would depend on each country's supply and demand for the
goods. For example, these points could be 35 units of wheat and 15 units of steel for
the U.S., and 10 units of wheat and 20 units of steel for Great Britain, as illustrated in Figure
5.1.
Trade Efficiency Rule
A general rule of efficiency is that an individual or group should specialize in production
activities in which it can operate more efficiently than other entities. This principle is referred
to as comparative advantage when discussing international trade theory; it states that the
worldwide production output is maximized when each country concentrates on producing
goods for which it has lower opportunity costs.

In Figure 5.1, the U.S. is the low-cost producer for wheat, as it only gives up one unit of
steel when it produces one unit of wheat. Great Britain is the high-cost producer for wheat,
as it must give up two units of steel for each unit of wheat produced. However, Great
Britain is the low cost producer for steel, as it gives up only one-half of a unit of wheat for
each unit of steel produced. Therefore, the U.S. has a comparative advantage in producing
wheat, while Great Britain has a comparative advantage in producing steel. According to the
trade efficiency rule, the world will be better off if Great Britain specializes in steel
production and the U.S. specializes in wheat production.

An easy way to determine which country has the comparative advantage is to compare the
slopes of the production possibility curves. Suppose you have production possibility curves
for two countries with product Y and X, and product Y is placed on the y-axis. The country
with the most negative slope for product Y will have the comparative advantage with
product Y.

Suppose each country specialized in producing the good for which it had a comparative
advantage. The U.S. would produce 50 units of wheat per worker and Great Britain would
produce 40 units of steel per worker. The combined world output would be 50 units of wheat
and 40 units of steel. With no trade, the combined wheat output is 45 units and the
combined steel output is 35 units. Clearly the two countries can benefit from trading with
one another - the quantity of wheat produced goes up by five units and the quantity of steel
produced goes up by five units. Trading offers more efficient production possibilities.

Terms of Trade
The next question to determine is what the terms of trade would be. Clearly the U.S. will not
accept less than one unit of steel per unit of wheat, as that is the cost if no trade occurs.
Also, we know that Great Britain will not accept less than one-half of a unit of wheat for its
steel, as that is the cost tradeoff without trade.

The actual terms of trade would need to lie somewhere in between these limits.
Suppose Great Britain offered five units of wheat for each five units of U.S. steel.
The U.S. would not accept such an offer for its steel production because five units of steel
could be traded for five units of wheat internally.

The actual terms of trade will depend on overall world and supply conditions, within the
limits just mentioned. However, trade will not occur unless the trade is mutually beneficial.

Suppose the terms of trade settle at 1.5 units of steel per unit of wheat. We can graph a
trading possibilities curve and relate that curve to the original production possibilities curve.

Figure 5.2: Trading Possibilities Curve

The slope of the trading possibilities curve will be -1.5 for each country. The original
production possibilities curve is shifted to the trading possibilities curve by specializing in
the production of the good for which each country has a comparative advantage and by
then engaging in international trade. As the possible amount of consumption increases for
both countries, they will each enjoy a higher standard of living.

Recall that we assume that without trade, the U.S. will consume 35 units of wheat and 15
units of steel for the U.S and that Great Britain will consume ten units of wheat and 20 units
of steel. These points are shown as Point A in both of the graphs above. With the trading
possibilities at -1.5, the U.S. could specialize in wheat production and then trade 12 units of
wheat for 18 units of steel. The country would then end up with 18 units of steel, and keep
38 units of its own wheat production. This point is described as Point B in the U.S. graph
above. Great Britain could benefit in a similar manner.

Note that the above analysis assumes that relative production costs are constant, which
allows for straight lines to be used as a production possibilities curve. In reality, as more
and more of a good is produced, relative production costs increase because less efficient
resources will be used as production increases. As a result, we expect that production
possibility curves will be curved lines. Therefore, specialization will not be an all-or-nothing
type of situation. Even if the U.S. is a relatively inefficient producer of steel, some steel
production will still occur in the United States. Similarly, while Great Britain will mostly be
producing steel, some wheat production will still occur in Great Britain.

Domestic producers of goods that are produced relatively cheaply will be able to get higher
prices in the world market. Suppose the U.S. is a relatively efficient producer of wheat. In
the Figure 5.3 below, the quantity demanded and the quantity supplied would be equal at
domestic price Pdw. However, U.S. wheat producers would prefer to export their goods at
the world price Pww. By doing so, they will achieve higher profits. Consumers will lose out
because they will have to pay higher world prices.
Figure 5.3: Effects of International Trade on Domestic Supply and Demand

However, for goods produced relatively inefficiently by the U.S., consumers will benefit by
paying lower prices. Using shirts as an example, we can see that without international trade,
consumers would pay price Pds for shirts. By allowing imports, consumers can pay the lower
price Pws. Producers are hurt because they will have to take the lower world price.

Figure 5.4: Effects of International Trade on Domestic Supply and Demand

Tariffs and Quotas

Tariffs
Tariffs are taxes imposed on imported goods; they will increase the price of the good in the
domestic market. Domestic producers benefit because they receive higher prices. The
government benefits by collecting tax revenues. In the graph below, S 0 and D0 represent the
original supply and demand curves which intersect at (P0, Q0). St shows what the supply
curve is with the introduction of the tariff. The market then clears at (P t, Qt). Less of the
good is produced, and consumers pay higher prices.
Figure 5.5: Effect of a Tariff on a Supply Curve

Quotas
Quotas are numerical limits imposed on imported goods. Consumers are harmed by quotas,
while domestic and foreign producers benefit by receiving higher prices. In the graph below,
the market initially clears at P0, Q0. The supply curve Sd+i0 represents the quantity supplied
by both domestic and foreign producers before the imposition of the quota. D 0 is the
domestic demand curve. After the quota, the supply curve looks like S d+i1. Both foreign and
domestic producers receive higher prices while consumers lose out.

Figure 5.6: Effect of Quotas on the Supply Curve

Voluntary Export Restraints (VERs)

These restraints limit the quantity of goods that can be exported from the country to one or
more of its trading partners. They are usually "voluntarily" negotiated so that quotas or
tariffs are not imposed.

Exchange Rate Controls

Exchange rate controls set the exchange rate of a nation's currency above the market rate.
This makes the nation's exports artificially expensive, which reduces the quantities of the
nation's goods that foreigners are willing to buy. This means that the country's citizens have
little foreign currency available to buy imported goods. With exchange rate controls, black
markets usually exist where currency exchange occurs at a market rate. Exchange rate
controls are declining in popularity, although some developing nations still use them.

"Hidden" Methods
Hidden methods of limiting imports include special regulations and licensing requirements
that restrict imports. For instance, the Japanese government imposes special quality
requirements on food to restrict food imports and protect Japanese farmers.

Trade Restrictions
Advantages and Disadvantages
Trade barriers reduce the possible quantity of goods that can be consumed and produced
within an economy. Prices will be higher, and there will be fewer choices with regards to
consumer goods.

Beneficiaries of a tariff include the government, which collects the tariff, and domestic
producers within the affected industry (or industries). The general public (consumers) loses.

Arguments in favor of trade restrictions include:

 National Defense - Foreign producers should not be relied upon for production of
defense goods, even if the goods can be produced at a lower cost abroad.
 Infant Industries - Start-up industries in a country may not be able to effectively
compete against foreign producers because of their small size. An argument can be
made that these industries should be protected until suitable economies of scale can
be achieved. If the economies of scale are such that the domestic industry achieves
a comparative advantage over foreign companies, the temporary protection will help
to achieve better economic efficiency
 Anti-Dumping - The claim is often made that foreign producers "dump" their goods
on the domestic market. The term dumping is applied when foreign producers are
thought to be selling goods at prices below their production costs, or below the
prices charged in their home market. Retaliatory measures may include the
imposition of tariffs, quotas or fines against foreign producers. The fear is that this
"unfair" practice will drive domestic producers out of business and that the foreign
producers will then impose monopoly pricing. One argument against this fear is that
when prices are raised at a later time, domestic producers can reenter the market.
Deliberately driving other producers out by selling at a loss usually does not work.
Another argument against "anti-dumping" is that the country as a whole benefits
when foreign-made goods are sold at lower prices than domestic ones. The reasons
for which the prices are lower should not be a primary concern.

Nations often adopt trade restrictions due to:

  Short-Sightedness - In the short-run, the imposition of a tariff may help to preserve
jobs in the relevant domestic industry. The effort to avoid unemployment in the
affected industry also makes for good politics. However, in the long-run, those
workers will find other jobs and the economy will be operating at full employment in a
more efficient manner.
 Special Interests - Special interests can use their powers to put trade restrictions in
place. Although free trade benefits the general public, it does not necessarily benefit
all groups within the economy. Management and workers in an industry impacted by
foreign goods will not willingly go through dislocation and adjustments (such as
retraining) that may be necessitated by foreign competition
 Economic Ignorance - Ignorance also contributes to the creation of trade
restrictions. Most members of the general public are not aware of the harm created
by trade restrictions.
 Visibility - The benefits of trade restrictions are large and highly visible for small,
select groups of people. The benefits of free trade are dispersed across the general
population and are, therefore, harder to see. It is easy to note jobs lost to foreign
competition; it is not easy to see that those displaced labor resources will be
reallocated to more efficient jobs.

International Finance
Law of Demand for Foreign Exchange
The law of demand for foreign exchange states that, all other factors remaining equal, the
quantity demanded of a particular currency will decrease (increase) as the exchange rate
goes higher (lower). Demand for a country's currency is derived from the goods or services
produced by that country. The purchase of a Japanese car by an American consumer will
necessitate the conversion of dollars to Japanese yen. As the exchange rate rises (in terms
of Japanese yen), Japanese cars will become more expensive to American consumers,
who will in turn buy fewer Japanese cars. The lower demand for Japanese cars will lead to
a decreased demand for the yen. If the exchange rate for the yen vs. the dollar goes down,
Japanese goods will be cheaper for American consumers. As a result, more Japanese
goods will be purchased and more dollars will be exchanged for yen.

Law of Supply for Foreign Exchange

The law of supply for foreign exchange states that, all other factors remaining equal, the
supplied quantity of a particular currency will increase (decrease) as the exchange rate
goes higher (lower). U.S. citizens supply U.S. dollars to the foreign currency market when
they buy foreign goods or services, or when they purchase foreign assets such as real
estate or stocks. As the exchange rate increases (e.g. the price of a U.S. dollar in terms of
Japanese yen goes from 100 yen per dollar to 110 yen per dollar), more U.S. dollars will be
supplied as U.S. citizens get more value for their "buck".

Factors Affecting the Quantity of Demand and Supply for Currency

There are two main factors that affect the quantities demanded and supplied for a particular
currency:
·Relative interest rates
·Expectations concerning future exchange rates

If, for example, interest rates in the United States are higher than those of other countries,
foreigners will want to convert their currencies to dollars in order to earn a higher rate of
return. Their actions will cause a reduction in the supply of dollars.

Expectations about future exchange rates will also impact current quantities demanded and
supplied for currencies. For example, suppose the current exchange rate for euros and
dollars is $1.20 per euro and an importer of European goods expects the euro to depreciate
next month to $1.1 per euro. That importer will hold off on converting dollars to euros
thereby decreasing the current quantity demanded for euros and the quantity supplied for
dollars.

How is the Exchange Rate Influenced by Supply and Demand

If the demand for a currency increases (decreases) while the supply remains the same, the
exchange rate will rise (decline) to achieve market equilibrium. If the supply of a currency
increases (decreases) while demand remains the same, the exchange rate will decline
(rise). Exchange rates can be volatile because supply and demand are affected by common
factors, such as interest rate differentials and expectations.

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 Canada than in the United States. We would then
expect U.S. consumers to buy those goods in Canada. Even if this is not possible from a
transportation or cost viewpoint, some businesses will have an incentive to buy the goods
cheaply in Canada and remarket them in the United States. Such actions would cause U.S.
dollars to be sold in exchange for Canadian dollars. As a result, the U.S. dollar would
depreciate in relation to the Canadian dollar. We would expect the currency depreciation to
continue until the bundle of goods costs the same in both countries.

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 U.S. banks. However,
exchange rate expectations also come into play. Suppose the investor expects the British
pound to appreciate at the rate of 2% in terms of the dollar. That investor would then be
indifferent to either investment choice, as both are expected to earn 6%.
 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.

Foreign Exchange
Direct and Indirect Methods of Foreign Exchange Quotations
With the direct method of foreign exchange quotation, the exchange rate is expressed as
the number of units of the domestic currency needed to acquire one (1.0) unit of the
pertinent foreign currency. Within the U.S., this method is also referred to as quoting
exchange rates in American (U.S.) terms.

With the indirect method of foreign exchange quotation, the exchange rate is expressed as
the number of units of the pertinent foreign currency needed to acquire one (1.0) unit of the
domestic currency. In the U.S., this method is referred to as quoting the exchange rate in
foreign terms.

ethods are reciprocals of one another.

Example: Currency Conversion

Suppose you are given the direct quote, in U.S. terms, between the U.S. dollar and the euro
as:

¬1.00 = $1.2830

The indirect quote between the U.S. dollar and the euro would then be calculated as the
reciprocal (1 / 1.2830), and we get the following indirect quote for the U.S. dollar:
$0.7794 = ¬1.00

Suppose you have the following indirect foreign exchange quote for the Japanese yen and
U.S. dollar, from a Japanese perspective:

¥109.38 = $1.00
The direct exchange quote for the Japanese yen to U.S. dollar, from a Japanese
perspective, will be the reciprocal of (1 / 109.38), and we then get:

$0.009142 = ¥1.00

Spread Calculations
Calculating Spread on a Foreign Currency Quote
Profits for currency market dealers are derived from the difference between the bid, which is
the exchange rate at which a dealer is willing to purchase a particular currency, and the ask,
which is the exchange rate for which a dealer is willing to sell a particular currency.

The difference between the two is called the bid-ask spread. Foreign currency dealers will
quote both a bid and an ask for a particular currency. The average of the bid and ask (ask
plus bid divided by two) is referred to as the midpoint price. The bid-ask spread is usually
given as a percentage and it is calculated as:

Formula 5.1

% Spread = 100 × (Ask Price - Bid Price)

Ask Price

Example: Bid-Ask Spread

Suppose that a dealer provides the following quote in the U.S. for euros to dollars:

Direct ($/¬): $0.8038/$0.8041

Then the bid-ask spread will be 100 × (0.8041 - 0.8038) / 0.8041 = 0.0373%, which is about
4 bps.

Factors Influencing the Size of Spreads

Factors that affect the size of spreads for spot or forward currency exchange rates include:

 Trading Volume - The higher the volume, or the more active a market, the lower the
bid-ask spread.
 Currency Rate Volatility - With higher volatility, currency dealers are exposed to
higher risk. Spreads will increase with higher volatility.
 Perceived Economic/Political Risks - Risks such as political instability, higher
inflation and changing economic conditions will affect the spreads associated with a
particular currency. The higher the uncertainty, the greater the expected spread.

Note that if a dealer has an overly large position in a currency relative to the desired net
position, the dealer will alter the midpoint of the spread rather than adjust the spread. For
instance, a dealer with a shortage of a particular currency will move the midpoint of the
direct quote up. Competition is also an important factor for spreads. A dealer with an overly
large spread will not be making trades.

Spot Market Calculations

Calculating Currency Cross Rates When Given Two Spot Exchange Quotes Involving
Three Currencies
A currency dealer located in a particular country will usually provide a set of exchange rate
quotations between the country's currency and various foreign currencies. The cross-rate
between two currencies not explicitly quoted is obtained by getting quotes for each currency
in terms of the exchange rate with a third nation's currency. Suppose you are told that the
exchange rate of the U.S. dollar per euro is 1.2440 and that the exchange rate for U.S.
dollar per British pound is 1.8146. The euro-to-pound cross rate can be calculated as the
euro-to-dollar rate multiplied by the dollar-to-pound rate, which is equal to (1/1.2440) ×
1.8146 = 1.4587, or ¬1.4587 per British pound. Note that this result is an indirect quote from
the viewpoint of a British entity, or a direct quote from the viewpoint of a business whose
domestic currency is the euro.

In general, in calculating cross-rates, bid and ask prices will need to be dealt with.

This makes the calculation only slightly more difficult. The following equations should be
kept in mind:

Formula 5.2

(FCa / FCb)ask = (FCa / DC)ask ×(DC/FCb)ask

(FCa / FCb)bid = (FCa / DC)bid ×(DC/FCb)bid

Where FCa and FCb are the two foreign currencies and DC is the domestic currency.

Similar equations are used when calculating FCb to FCa exchange rates.

Example: Currency Cross Rates and Ask Quotations

Verifications can be made by checking that (FCb/FCa)ask is equal to the reciprocal of
(FCa/FCb)bid, and by checking that (FCb/FCa)bid is equal to the reciprocal of (FCa/FCb)ask.

Suppose you are given the following bid/ask quotations for two foreign currencies against
the domestic currency, the U.S. dollar:

Bid Ask
¬ / $ 0.9002 0.9023
¥ / $ 109.38 109.40
 We want to calculate what the ¥ / ¬ bid and ask quotations will be.

Answer:
The ¥ / ¬ bid price will be the number of yen the dealer is willing to pay in order to buy one
euro. This transaction would be the equivalent of selling yen to purchase dollars (at the bid
rate of 109.38), and simultaneously reselling the dollars to purchase euros (at the ask rate
of 0.9023). The bid ¥ / ¬ would be calculated as 109.38/0.9023 = 121.22.

The ¥ / ¬ ask price would be the number of yen the dealer wants to receive in exchange for
selling one euro. This transaction would be the equivalent of buying yen with dollars (at the
109.40 ask rate) and at the same time buying those dollars with euros, at the 0.9002 bid
rate. The transaction could be expressed mathematically as:

Ask ¥ / ¬ = 109.40 / 0.9002 = 121.53

So the resulting dealer quotation would be:

¥ / ¬ = 121.22 - 121.53

the exam, so make sure that you are comfortable with these types of questions.

Spot vs Forward Markets Within Foreign Exchange

There are two types of markets for setting currency exchange rates:

1. The Spot Currency Exchange Market - This market involves trades of currencies
for immediate delivery. Settlement usually occurs two days after the trade date.
Participants in this market want to convert to the other currency relatively quickly.
Transactions in the spot market are often used for investments, or to settle
commercial purchases of goods.
2. The Forward Currency Exchange Market - This market involves contracts for
currency exchange in which settlement will take place more than two days after the
trade date. While settlement dates are negotiable, standard foreign currency forward
contracts usually settle 30, 90 or 180 days after the trade date. If a dealer quotes the
90-day ¥ / $ exchange rate at 109.80-109.83, that means the dealer is willing to
commit today to buying dollars for 109.80 yen in 90 days, or to selling dollars at
109.83 yen per dollar 90 days from today.

Forward Market Calculations

Spreads on Forward Currency Quotations
The spread on a forward currency quotation is calculated in the same manner as the spread
for a spot currency quotation.
The reasons that spreads vary with forward foreign currency quotations are similar to the
reasons for the variability of spreads with spot foreign currency quotations. The unique
factor associated with spreads for forward foreign currency quotations is that spreads will
widen as the length of time until settlement increases. Currency exchange rates would be
expected to have a higher range of fluctuations over longer periods of time, which increases
dealer risk. Also, as time increases, fewer dealers are willing to provide quotes, which will
also tend to increase the spread.

Calculating a Forward Discount or Premium, Expressed as an Annualized Rate.

Forward currency exchange rates often differ from the spot exchange rate. If the forward
exchange rate for a currency is higher than the spot rate, there is a premium on that
currency. A discount exists when the forward exchange rate is lower than the spot rate. A
negative premium is equivalent to a discount.

Example: Forward Discount Premium

If the ninety day ¥ / $ forward exchange rate is 109.50 and the spot rate is ¥ / $ = 109.38,
then the dollar is considered to be "strong" relative to the yen, as the dollar's forward value
exceeds the spot value. The dollar has a premium of 0.12 yen per dollar. The yen would
trade at a discount because its forward value in terms of dollars is less than its spot rate.

The annualized rate can be calculated by using the following formula:

Formula 5.3

Annualized Forward Premium = Forward Price - Spot Price x 12 x 100%

Spot Price # of months

Answer:

So in the case listed above, the premium would be calculated as:

Annualized forward premium=

((109.50 - 109.38 ÷ 109.38) × (12 ÷ 3) × 100% = 0.44%

Similarly, to calculate the discount for the Japanese yen, we first want to calculate the
forward and spot rates for the Japanese yen in terms of dollars per yen. Those numbers
would be (1/109.50 = 0.0091324) and (1/109.38 = 0.0091424), respectively.

So the annualized forward discount for the Japanese yen, in terms of U.S. dollars, would
be:
((0.0091324 - 0.0091424) ÷ 0.0091424) × (12 ÷ 3) × 100% = -0.44%

Interest Applications
Interest Rate Parity
Interest rate parity enforces an essential link between spot exchange currency rates,
forward currency exchange rates and short-term interest. It specifies a relationship that
must exist between the spot interest rates of two different currencies if no arbitrage
opportunities are to exist. The relationship depends on the spot and forward exchange rates
between the two currencies.

The following example illustrates what interest rate parity is and why it must exist.

Example:
Assume the following data for the euro (¬) and the U.S. dollar ($):

One-year forward exchange rate ¬/$ = 0.909

Spot exchange rate ¬/$ = 0.901

One-year interest rate, euro 7%

One-year interest rate, dollar 5%

A speculator could borrow dollars at 5%, convert them into euros and invest the euros at
7%. The speculator would be making a profit of 2%.

However, at the end of the time period, euros will need to be converted to dollars so that the
initial borrowing can be repaid. The speculator runs the risk that dollars may have
depreciated relative to the euro during that time period.

The speculator's position can potentially be made into a risk-free one by purchasing a
forward exchange contract so that the exchange rate used to convert euros back to dollars
is a known one.

Over one year, the speculator would experience the following exchange rate loss:(0.901 -
0.909) ÷ 0.901 = -0.9%

Because of the 2% interest rate differential, the speculator makes a net profit of 1.1% for
each dollar borrowed. This is a certain gain, as all exchange and interest rates were fixed
and known at the beginning of the trade, and no capital had to be invested in the position
either!

If such rates existed in the real world, enormous swaps of capital would be made to take
advantage of such a risk-free arbitrage. To prevent this from occurring, the forward discount
rate would have to equal the difference in interest rates. Note that if the discount forward
rate is greater than the interest rate differential, the arbitrage will be made in the other
direction.

The actual mathematical relationship is slightly more complicated than what was specified
above because a perfect arbitrage would require that the forward contract cover both the
 initial principal borrowed plus the accrued interest. For the rates discussed above, the
speculator would actually need to hedge, for every dollar borrowed, 0.901 (1.07) = 0.964.

The interest rate parity relationship between two currencies can be expressed (using
indirect quotes) as:

Formula 5.4

(Forward rate - Spot rate) ÷ Spot rate = (rfc - rdc) ÷ (1 + rdc)

or (F - S) ÷ S= (rfc - rdc) ÷ (1 + rdc)

Where rdc is the risk-free interest rate of the domestic currency, rfc is the risk-free interest
rate of the foreign currency and the exchange rates quoted are indirect quotes expressed
as the number of units of the foreign currency used to obtain one unit of the domestic
currency.

The interest rate parity relationship can also be expressed as:

F × (1+ rdc) = S × (1 + rfc)

sociated with lower interest rates. Weak currencies must have high risk-free interest rates to compensate for expected depreciation.

Foreign Exchange Parity Relations

How Exchange Rates are Determined
With a flexible or floating exchange rate system, the value of a currency, as related to other
currencies, is determined by the market forces of supply and demand. Suppose that the
current exchange rate between the U.S. dollar and British pound is $1.50 = 1 British pound
and that Americans then increase their purchases of British goods, while the purchase
of U.S. goods by the British stays the same.

We would then expect that at that exchange rate, more U.S. dollars are available than are
demanded. The exchange rate of the U.S. dollar would be expected to go down until a new
equilibrium is achieved. Shifts in supply and demand for a nation's currency will cause the
nation's currency to appreciate or depreciate.

One advantage of a floating exchange rate system is that it reflects existing economic
fundamentals. Another advantage is that governments are not forced to defend some
particular exchange rate (or range of rates), and are free to adopt fiscal or monetary policies
that are independent of the exchange rate.
 If you are baffled by exchange rates, or if you are just curious about why some currencies
fluctuate while others don't, the following article has the answers:
Floating and Fixed Exchange Rates

The Balance of Payments

The balance of payments measures all financial flows that cross a country's border during a
given period of time, typically a quarter or a year. It renders an account of all payments and
liabilities to foreigners, and all payments and obligations received from foreigners. For
example, when a U.S. company sells a product overseas, that export creates a financial
inflow to the U.S., while an American citizen purchasing an imported item creates a
negative financial inflow (an outflow). By definition, the sum of all the components of the
balance of payments must be equal to zero.

With regard to balance-of-payments accounts, there are three major types of accounts:

1.The Current Account - This type of account records transactions with foreign countries
for all current transactions that take place as part of normal business. The current account
is specifically made up of:

·Imports and exports, which is also called the trade balance or balance of merchandise
trade
·Services, such as accounting and insurance
·Factor payments, such as interest and dividends paid
·Current transfers such as gifts, which do not have an associated exchange factor

2.The Financial Account - Also known as a balance-on-capital account, this account

covers changes in ownership of financial and real investments. Parts of this account
include:

·Net foreign purchases of long-term domestic assets, such as bonds, stock, real estate and
other business assets, netted against similar purchases of foreign assets made by the
country's citizens
·Private transfers of financial assets such as cash and other forms of payments made by
domestic entities to foreigners in order to settle balances owed to the foreigners, netted with
similar transfers of financial assets from foreigner to domestic entities.

3.The Official Reserve Account - This account keeps track of all transactions made by
monetary authorities. The sum of the current and financial accounts, which is called
the overall balance, should be equal to zero. The central bank can use some of its
reserves when the overall balance is negative. If the overall balance is positive, the central
bank can choose to add to its reserves.

understanding later sections.

The following page will prime you for the topics discussed in this section:
What is the Balance of Payments?

Currency Appreciation and

Depreciation
Current and Financial Account Surpluses and Deficits
Current account deficits (or surpluses) and financial deficits (or surpluses) do not directly
affect an economy. In fact, these deficits (surpluses) are actually the result of what is
occurring in an economy, instead of being the cause. Trade deficits often occur when a
nation's economy is growing faster than the economies of its trading partners. Rapid
domestic growth increases the demand for imports, while slow or no growth with foreign
economies can cause a decline in demand for the country's exports.

Trade balances are also affected by capital flows. If a nation's economy offers investment
opportunities that are relatively better than other nations, then capital will flow into the
country. With flexible exchange rates, this capital inflow will tend to increase the value of the
nation's currency.

Economic statistics support the hypothesis that trade deficits are associated with investment
opportunities and economic growth. Between 1973 and 1982, which was a time of stagnant
economic growth for the U.S., trade deficits and net foreign investment were fairly small. As
the U.S. economy grew rapidly after the 1982 recession, net foreign investment greatly
increased. During the recession of the early 1990s, capital inflow greatly decreased and the
current account was actually slightly positive during one of those years. The time between
1993 and 2000 was one of substantial economic growth; net capital inflows greatly
increased, which caused the U.S. dollar to appreciate and the current account ran large
deficits.

Budget deficits and trade deficits tend to be linked

An increase in the U.S. government budget deficit will cause an increase in the real interest
rate, which causes additional foreign capital to flow into the country. The inflow of foreign
currencies will cause the value of the U.S. dollar to increase in relation to other currencies.
The increase in value of the U.S. dollar will make U.S. exports relatively less attractive to
foreigners and imports into the U.S. will be relatively less expensive; therefore, net exports
will go down. The increase in the budget deficit leads to an increase in the trade deficit.

Causes of a Nation's Currency Appreciation or Depreciation

Factors that can cause a nation's currency to appreciate or depreciate include:

·Relative Product Prices - If a country's goods are relatively cheap, foreigners will want to
buy those goods. In order to buy those goods, they will need to buy the nation's currency.
Countries with the lowest price levels will tend to have the strongest currencies (those
currencies will be appreciating).

·Monetary Policy - Countries with expansionary (easy) monetary policies will be increasing
the supply of their currencies, which will cause the currency to depreciate. Those countries
with restrictive (hard) monetary policies will be decreasing the supply of their currency and
the currency should appreciate. Note that exchange rates involve the currencies of two
countries. If a nation's central bank is pursuing an expansionary monetary policy while its
trading partners are pursuing monetary policies that are even more expansionary, the
currency of that nation is expected to appreciate relative to the currencies of its trading
partners.

·Inflation Rate Differences - Inflation (deflation) is associated with currency depreciation

(appreciation). Suppose the price level increases by 40% in the U.S., while the price levels
of its trading partners remain relatively stable. U.S. goods will seem very expensive to
foreigners, while U.S. citizens will increase their purchase of relatively cheap foreign goods.
The U.S. dollar will depreciate as a result. If the U.S. inflation rate is lower than that of its
trading partners, the U.S. dollar is expected to appreciate. Note that exchange rate
adjustments permit nations with relatively high inflation rates to maintain trade relations with
countries that have low inflation rates.

·Income Changes - Suppose that the income of a major trading partner with the U.S., such
as Great Britain, greatly increases. Greater domestic income is associated with an
increased consumption of imported goods. As British consumers purchase
more U.S. goods, the quantity of U.S. dollars demanded will exceed the quantity supplied
and the U.S. dollar will appreciate.

Effect of Monetary Policy

Unanticipated changes in monetary policy will produce both price (substitution) and income
effects. For example, suppose monetary authorities begin a program of expansionary (easy)
monetary policy.

We would then expect the following sequence of events to occur with regard to the price
effect:

·Real interest rates will be reduced.

·As real interest rates are reduced, domestic financial and capital assets become less
attractive as a result of their lower real rates of return. Foreigners will reduce their positions
in domestic bonds, real estate, stocks and other assets. The financial account (or balance
on capital account) will deteriorate as a result of foreigners holding fewer domestic assets.
Domestic investors will be more likely to invest overseas in the pursuit of higher rates of
return.
·The reduction in domestic investment by foreigners and the country's citizens will decrease
the demand for the nation's currency and increase the demand for the currency of foreign
countries. The exchange rate of the nation's currency will tend to decline.
·With no government intervention, the financial account and the current account must sum
to zero. As the financial account declines, the current account will be expected to improve
by an equal amount. In other words, the balance of trade should improve. The country's
export will have become relatively cheaper and imports will be relatively more expensive.
The effect of an expansionary monetary policy is to lower the exchange rate, weaken the
financial account and strengthen the current account. A restrictive monetary policy would be
expected to result in the opposite: a higher exchange rate, a stronger financial account and
a weaker current account (a more negative, or a less positive balance of trade).

With a program of expansionary (easy) monetary policy, the following sequence of events
would be expected to occur with regard to the income effect:

·The domestic GDP will rise.

·The rise in domestic GDP will tend to increase the demand for imports. The increase in
imports will cause the current account to deteriorate.
·The increase in imports purchased will increase the need to convert domestic to foreign
currency. As a result, the exchange rate of the domestic currency will decrease.
·With no government intervention, the financial account must now move toward a surplus as
the financial and current account must sum to zero. Due to the increase in imports,
foreigners will now have a surplus of the nation's currency. If foreigners do not use that
currency to purchase the country's exports (which would improve the current account
balance), they will ultimately need to invest that currency in the assets of the domestic
country. This explains why countries such as China and Japan invest large sums in assets
such as U.S. Treasuries. The holders of the U.S. currency must put it to work somewhere!
Note that foreign investors are often getting better rates of return than what might be readily
apparent because the value of the domestic currency is falling relative to their own
currency.

In summary, the income effect of expansionary monetary policy tends to lower the domestic
currency exchange rate, weaken the current account and work to improve the financial
account. A restrictive monetary policy tends to cause the opposite due to the income effect.
The domestic currency exchange rate increases, the current account improves and the
financial account weakens.

As both price and the income effects of monetary policy move in the same direction
regarding their impact on the exchange rate, it is clear that expansionary (restrictive)
monetary policy will lower (raise) the country's exchange rate. The effect of monetary policy
on the current and financial accounts is not so clear because the price and income effects
move in opposite directions. For example, the price effect of easy money on the current
account tends to strengthen it, while the income effect tends to weaken the current account.
Since the effects move in opposite directions, it is not immediately clear what the ultimate
impact will be.

We should note that investors can buy and sell financial assets such as stocks and bonds
more quickly than producers and consumers can sell and buy physical goods. So initially,
interest rate (substitution) effects would be expected to dominate. An unanticipated increase
in the money supply will cause the exchange rate to go down, the financial account to
weaken and current account to gain strength. Over time, the income effect will come into
play. A rising GDP will cause both the trade balance and financial account to weaken.
Some argue that for an economy with a foreign sector, monetary policy can create cyclical
movements that tend to destabilize an economy. Unanticipated expansionary monetary
policy initially causes the trade balance to improve, but as time progresses, it causes the
trade balance to become more negative. It initially causes the capital account to weaken
due to lower interest rates, but then later tends to improve it. In the long run, the main effect
of the expansionary monetary policy is a lowering of the nation's currency exchange rate,
which is the international equivalent to the long-run effect of expansionary monetary policy,
inflation. Empirical evidence indicates that countries with high rates of monetary supply
growth experience both inflation and declining currency exchange rates. An important point
to consider is the exchange rates of two countries - their relative rates of money supply
growth will help determine how the exchange rate changes.

Fiscal policy changes will produce both price (substitution) and income effects for exchange
rates and balance of payments. Suppose government policymakers enact a program of
unanticipated fiscal stimulus. This would be expected to cause the following sequence of
events to occur with regard to the price effect:

·Greater government budget deficits caused by tax cuts and/or increased spending will
increase the demand for investable funds, which will cause interest rates to rise.
·The increase in interest rates will cause capital inflows (foreigners will purchase more
domestic financial assets). As a result, the capital account will strengthen (become more
positive or less negative).
·Foreign investors will need to exchange their currency for the domestic currency. The
increased demand for the domestic currency will cause its exchange rate to increase.
·If there is no government intervention with the balance-of-payments, the current account
will need to become more negative (or less positive). The trade balance will weaken as
imports increase and/or exports decrease. This makes sense because the strengthening of
the nation's currency will make its exports relatively less attractive to foreigners and imports
will be less expensive relative to the country's consumers and domestic businesses.

To summarize, the price effect of a stimulative fiscal policy is to raise the value of the
domestic currency, strengthen the capital account and weaken the current account. A
restrictive fiscal policy would have the opposite effects: a weaker domestic currency, a
weaker capital account (there would be net capital outflows) and a stronger current account.

With a program of fiscal stimulus, the following sequence of events would be expected to
occur with regard to the income effect:

·The tax cuts and/or increase in government spending associated with the fiscal policy, and
the associated multiplier effect, will increase GDP.
·The rise in GDP will cause the demand for imports to increase and the current account will
be weakened (become more negative or less positive).
·More domestic currency will need to be converted into foreign currencies to purchase the
increased quantity of imports. The increased supply of domestic currency on the
international markets will cause the exchange rate to decline.
·With no government intervention, the financial account will need to become more positive
(or less negative) in order to compensate for the weakening of the current account.
Foreigners will be holding more of the domestic currency and are therefore in a position to
purchase more of the nation's financial assets. Also, as the domestic economy is improving,
they may find it more attractive as a place to invest.

To summarize, the income effect associated with fiscal stimulus will tend to lower the
exchange rate of the country's currency, weaken the current account (trade balance) and
strengthen the financial account.

Fiscal policy price and income effects move in the same direction with regard to their impact
on the financial and current accounts. Stimulating fiscal policy will clearly weaken the
current account (balance of trade) and strengthen the capital account. Restrictive fiscal
policy will strengthen the current account (balance of trade) and weaken the capital
account.

The impact of fiscal policy on exchange rates is not so clear because the price and income
effects work in opposite directions. The income effect tends to weaken the currency
exchange rate, while the price effect will tend to strengthen the currency exchange rate.
Because foreign investors can trade financial assets (such as stocks and bonds) more
quickly and easily than consumers and producers can alter the purchase and sale of
physical assets, the price effect would be expected to have the larger initial effect. Over
time, the income effect will increasingly come into play.

So initially, the fiscal stimulus should cause the domestic currency to appreciate. Over time,
as the demand for imports is stimulated, the domestic currency will weaken. If the fiscal
stimulus is associated with inflation, there will be a further weakening of the domestic
currency. Note that the fiscal stimulus will also have the effect of worsening the balance of
trade and increasing the financial account in both the short and long run.

A stimulative fiscal policy is good for the economy when it is operating below full
employment levels. There are a couple of factors that will mitigate the positive effects. One
factor is that government deficits will work to increase interest rates, which can crowd out
private investment. Another factor is that after foreign capital comes in (due to higher
interest rates), the domestic currency exchange rate rises. This leads to a rise in imports,
which reduces GDP. These two factors lessen the positive effects of fiscal policy stimulus.

Fixed vs. Pegged Exchange Rate

Systems
A fixed exchange rate system maintains fixed exchange rates between currencies; those
rates are referred to as official parity. A nation with fixed exchange rates must enforce those
rates. An early form of fixed exchange rates was to specify the value of a nation's currency
in terms of gold (the "gold standard").

The Gold Standard

The gold standard system worked reasonably well during the 1800s, but it was gradually
disbanded during the twentieth century. In 1944, leading non-communist nations agreed on
a fixed exchange rate system (the Bretton Woods System) whereby the value of the U.S.
dollar was pegged at $35 per ounce and other nations then fixed the value of their
currencies in relation to the U.S. dollar. Private individuals could not acquire gold at that
price; only governments traded gold at that price. During the 1960s, the U.S. government
pursued an expansionary monetary policy in an attempt to finance the Vietnam War and
increase domestic entitlement programs ("guns and butter") without raising taxes. The
inflationary monetary policy induced nations to begin a run on U.S. gold, and the U.S. was
forced to stop redeeming dollars for gold and break the fixed exchange rate system that had
been started in 1944.

Read more on the Gold Standard's rise and fall in the following article:
The Gold Standard Revisited

A nation operating under a fixed exchange rate system (pegged to the dollar) that
experiences a balance of payments deficit will be forced to finance the deficit out of its dollar
reserves. As the number of dollars declines, the nation's money supply is reduced. This
causes prices to drop and interest rates to increase. The price drops make the nation's
goods more competitive internationally; the higher interest rates also cause more capital to
flow into the country. These forces help the nation to achieve equilibrium with its balance of
payments.

The advantages of fixed exchange rate systems include the elimination of exchange rate
risk, at least in the short run. They also bring discipline to government monetary and fiscal
policies. Disadvantages include lack of monetary independence and increases in currency
speculation regarding possible revaluations.

Pegged Exchange Rate System

A pegged exchange rate system is a hybrid of fixed and floating exchange rate regimes.
Typically, a country will "peg" its currency to a major currency such as the U.S. dollar, or to
a basket of currencies. The choice of the currency (or basket of currencies) is affected by
the currencies in which the country's external debt is denominated and the extent to which
the country's trade is concentrated with particular trading partners. The case for pegging to
a single currency is made stronger if the peg is to the currency of a principal trading partner.
If much of the country's debt is denominated in other currencies, the choice of which
currency to peg it to becomes more complicated.

Typically, with a pegged exchange rate, an initial target exchange rate is set and the actual
exchange rate will be allowed to fluctuate in a range around that initial target rate. Also,
given changes in economic fundamentals, the target exchange rate may be modified.

Pegged exchange rates are typically used by smaller countries. To defend a particular rate,
they may need to resort to central bank intervention, the imposition of tariffs or quotas, or
the placement of restrictions on capital flow. If the pegged exchange rate is too far from the
actual market rate, it will be costly to defend and it will probably not last. Currency
speculators may benefit from such a situation.Advantages of pegged exchange rates
include a reduction in the volatility of the exchange rate (at least in the short-run) and the
imposition of some discipline on government policies. One disadvantage is that it can
introduce currency speculation.
Absolute and Relative Purchasing
Power Parity
Purchasing power parity is the notion that a bundle of goods in one country should cost the
same in another after exchange rates are considered.

There are two ways to express this concept:

1. Absolute Purchasing Power Parity

This concept posits that the exchange rate between two countries will be identical to the
ratio of the price levels for those two countries. This concept is derived from a basic idea
known as the law of one price, which states that the real price of a good must be the same
across all countries. To illustrate why this makes sense, suppose that soybeans are
currently priced at $5 a bushel in the U.S., that soybeans are priced at ¬5.50 per bushel
in Europe, and that the exchange rate is 1.10 euros per dollar. Suppose that the price of
soybeans goes up to ¬6.05 per bushel (a 10% increase) in Europe, while the price of
soybeans in the U.S. only goes up on 5%, to $5.25 a bushel. If there is no depreciation in
the euro to offset the 5% difference, then European soybeans will not be competitive on the
international market and trade flowing from the U.S. to Europe will greatly increase.

If we take weighted averages of prices for all goods within an economy, absolute purchase
power parity maintains that the currency exchange rate between two countries should be
identical to the ratio of the two countries' price levels.

This relationship can be expressed as:

Formula 5.5
S= P ÷ P*

Where Sis the spot exchange rate between two countries (the rate of the amount of foreign
currency needed to trade for the domestic currency), P is the price index for a domestic
country and P* is the price index for a foreign country. Note that the exchange rate used
here is an indirect quote.

The following conditions must be met for this relationship to be true:

1.The goods of each country must be freely tradable on the international market.

2.The price index for each of the two countries must be comprised of the same basket of
goods.

3.All of the prices need to be indexed to the same year.

 Even if the law of one price holds for each individual good across countries, differences in
weighting will cause absolute purchasing power parity. Determining comparable average
national price levels is actually quite difficult and is rarely attempted. Analysts usually
examine changes in price levels (indexes), which are easier to calculate; this gets around
some of the problems of comparability.

Relative Purchasing Power Parity

Relative purchasing power parity relates the change in two countries' expected inflation
rates to the change in their exchange rates. Inflation reduces the real purchasing power of a
nation's currency. If a country has an annual inflation rate of 10%, that country's currency
will be able to purchase 10% less real goods at the end of one year. Relative purchasing
power parity examines the relative changes in price levels between two countries and
maintains that exchange rates will change to compensate for inflation differentials.

The relationship can be expressed as follows, using indirect quotes:

Formula 5.6
S1 / S0 = (1 + Iy) ÷ (1 + Ix)

Where,
S0 is the spot exchange rate at the beginning of the time period (measured as the "y"
country price of one unit of currency x)
S1 is the spot exchange rate at the end of the time period.
Iy is the expected annualized inflation rate for country y, which is considered to be the
foreign country.
Ix is the expected annualized inflation rate for country x, which is considered to be the
domestic country.

he quantity of currency y (the foreign currency) needed to purchase one unit of currency x (the domestic currency). If we want the spot
ot $1.50 per British pound.

Example 1:
Suppose that Mexico's expected annual rate of inflation is equal to 6% per year, while the
expected annual inflation rate for the U.S. is 3%. As an approximation, we would expect that
the Mexican peso would depreciate at the rate of 3% per year (or we could say that the U.S.
dollar should appreciate at the rate of 3% per year.

Example 2:
Suppose that the annual inflation rate is expected to be 8% in the Eurozone and 2% in
the U.S. The current exchange rate is $1.20 per euro (¬1.00 = $1.20). What would the
expected spot exchange rate be in six months for the euro?
Answer:
So the relevant equation is:

S0.5 ÷ S0 = (( 1 + Ius) ÷ (1 + Ieurozone))0.5

= S0.5 ÷ $1.20 per euro = (1.02 ÷ 1.08)0.5

Which implies S0.5 = (1.20) × 0.978125 = 1.1662

So the expected spot exchange rate at the end of six months would be $1.1662 per euro.

Example 3:
Assume that the U.S. is the foreign country and that Japan is the domestic country. The
current spot exchange rate is S0 = 115 yen per dollar ($1 per ¥115.00). The expected
annual inflation rate for the U.S. is 4.89%, and the annual expected Japanese inflation rate
is 6.23%. Compute the approximate expected spot rate and the expected spot rate one year
from now.

Answer:
Because Japan is the domestic country we have:

S0 = 115 yen per dollar. (1 + Iy) is 1.0489, and (1 + Ix) is equal to 1.0623.

The approximation method would indicate that the yen should decline against the dollar
by: (Iy - Ix) =(1.0489 - 1.0623) = -0.0134 = -1.34%

So the value of the yen relative to the dollar would be expected to decline to

(1 - 0.0134) × 115 = ¥113.46 per $

We can calculate the rate more exactly as:

S1 = (1.0489) / (1.0623) × 115 = ¥113.55 per $

Purchasing Power Parity and Real Return on Assets

The purchasing power parity principle also applies to the real returns on assets earned by
various investors across the world. It holds that the real rate of return on assets should be
the same for investors from any nation.

Suppose that a financial asset from Mexico has an annual rate of return of 10% in Mexican
pesos. Assume that Mexico has an annual inflation rate of 4%, the U.S. has an annual
inflation rate of 2% and that the U.S. dollar is appreciating by 2% a year, as predicted by
purchasing power parity.

By the approximation method, U.S. investors would be earning about 8% per year in terms
of Mexican pesos. Their real rate of return would be approximately 6% per year
after U.S. inflation is taken into account. This is equal to what Mexican investors are
earning, which is about 6% (10% nominal rate of return - 4% inflation). All investors are
 getting the same real rate of return on specific assets.

Note that purchasing power parity is a theoretical concept that may not be true in the real
world, especially in the short run.

uire purchasing power parity calculations, so it is a good idea to practice solving questions such as the examples given ab