Question

1. Explain the logic behind the application purchasing power price theory to explain changes in the spot exchange rate.

2. Assume US interest rates are generally above foreign interest rates.

a. what does this sideway about the future strength or weakness of the dollar based on the IFE (international Fisher effect)?

b. should US investors invest in foreign securities if they believe in the IFE?

c. should foreign investors invest in US securities if they believe in the IFE?

Answer 1

Ans...
1.
Purchasing Power Parity assumes that two goods should sell at the same price in two different geographies, assuming there are no taxes or transportation costs. (However, in real world these assumptions don't hold true).
Spot exchange rates move mostly to make this above theory good. So long as the theory doesn't hold true, there will be an arbitrage opportunity. So long as this opportunity persists there will be a deviation in exchange from its fair value. Continuous arbitrage shall ensure that the spot exchange rate moves to its fair value.
2
a) Since the US rates are higher than the foreign rates, the dollar is expected to depreciate based on the IFE.
b) US investors should invest in foreign securities since the return on the USD will be more from the foreign securities.
c) Foreign investors should not invest in US securities because the return in the local currency would be less