Question

a) Show that when relative PPP holds, r(AU) = r(EU). Note: r denotes real interest rate.

b) Assume that worker productivity is expected to increase in the European tradables sector in the future. Assume further that worker productivity is expected to stagnate in European non-tradables sector as well as in all Australian sectors (tradables and non-tradables) in the future. What implication does this have on the difference between real interest rates in Australia and Europe?

c) Do real interest differences imply unnoticed profit opportunities for international investors? Explain.

Answer 1

A) The relative price levels determine the exchange rate.

♦ If the price level in the US is US$200 per consumption basket, while the price level in Canada is C$400 per basket, PPP implies that the US$/C$ exchange rate should be US$200/C$400 = US$ 1/C$ 2

♦ Purchasing power parity says that each country’s currency has the same purchasing power: 2 Canadian dollars buy the same amount of goods and services as does 1 US dollar, since prices in Canada are twice as high.

♦ Equivalently, PPP states that countries’ price levels are equal when measured in the same currency.

B) An anticipated world capital shortage which reflects projected demands for fund
s from eastern Europe, the Soviet Union and the Middle East, piled on top of the on-going and increasing demands from traditional developed and developing countries.

Every decade, however, generates massive demands for capital, which are bound to outstrip the funds available. In the 1990s, as in earlier decades, the rationing will ultimately occur in the market place; proposals which do not generate acceptable rates of return will not go ahead (or, if they do, they do so at the expense of other, more productive projects). Our hunch is that it will be some years yet before projects in eastern Europe or the Soviet Union can jump the required hurdle rates of return in such numbers as to impose major additional demands on world capital markets.

While,

Australia must still compete with all comers for its share of the world's scarce capital

Short-term real rates have been declining in Australia over recent years although they remain relatively high. As the economy slowed and inflationary pressures receded, nominal interest rates were lowered while retaining the anti-inflationary stance of monetary policy. They were lowered further than the fall in inflation so that real interest rates also fell – which was appropriate, given the phase of the cycle.

C) Investment in the national income accounts includes the change in inventories. In the short run inventory investment is highly variable, but over longer periods it's small potatoes relative to investment in physical capital, what we call "fixed investment.

Among the factors that influence firms' decisions of how much to invest are: (i) Productivity of future capital. If productivity of capital is high, the return from investment will be high. Thus an innovation that raises future productivity will lead to more investment, other things equal. (ii) The real interest rate.

Suppose firms finance investment through borrowing. Then the investment raises profits if the return is greater than the interest payments (technically, if the project has positive net present value). At high rates of interest fewer projects will be profitable, hence there will be less investment. (iii) Corporate taxes lower the after-tax return from investment projects, and thus reduce the amount of investment at any given rate of interest.