Question

1. Exchange rates are affected by the law of one price and purchasing power parity (PPP) in the long-run. Exchange rates are affected by the interest-rate parity condition in the short-run (Interest rate on domestic bond = Interest rate on foreign bond minus Expected appreciation of the domestic currency). What do these mean?

Answer 1

The PPP principle means that if there is a difference in the rates of inflation in two countries, then their exchange rate between today and, say, one year from now, will get adjusted to incorporate the difference in rates of inflation. More specifically, the country with the higher rate of inflation will experience a depreciation in its currency against the other country.

Similarly, if the rates of interest on securities in the two countries are different, then the exchange rate will adjust to take into account the difference. More specifically, the country with a higher rate of interest will experience a depreciation in its currency against the currency of the country with a lower rate of interest. This ensures that nobody is able to take advantage of the arbitrage opportunity to borrow in the country with the lower rate of interest and lend in the country with the higher rate of interest and make money without doing anything.