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Questions and Answers
What is likely to happen to the PLN/USD exchange rate when the Polish central bank increases its base rate?
What is likely to happen to the PLN/USD exchange rate when the Polish central bank increases its base rate?
- The PLN/USD rate will decrease immediately.
- The PLN/USD rate will remain unchanged regardless of interest rates.
- The PLN/USD rate will increase as Polish assets become more attractive. (correct)
- The PLN/USD rate will fluctuate without any predictable pattern.
Which factor contributes to the appreciation of the spot exchange rate according to the content?
Which factor contributes to the appreciation of the spot exchange rate according to the content?
- Foreign markets becoming more stable.
- Home assets providing lower yields than foreign assets.
- A decrease in the base interest rate.
- Increased attractiveness of home assets due to higher yield. (correct)
In the context of UIRP and PPP, what does a rate hike signal about future inflation?
In the context of UIRP and PPP, what does a rate hike signal about future inflation?
- Inflation rates will likely decrease by more than anticipated.
- Inflation will not affect the nominal interest rates in the long-term.
- A rise in nominal interest rates indicates expected higher inflation. (correct)
- It suggests that inflation will remain stable at current levels.
According to the relationship given, how does the nominal interest rate relate to inflation?
According to the relationship given, how does the nominal interest rate relate to inflation?
What is the correct formula representing the relationship between interest rates and expected changes in the exchange rate?
What is the correct formula representing the relationship between interest rates and expected changes in the exchange rate?
What adjustment occurs in the spot exchange rate if the domestic interest rate increases while the expected future exchange rate remains constant?
What adjustment occurs in the spot exchange rate if the domestic interest rate increases while the expected future exchange rate remains constant?
In a credible fixed exchange rate system, which condition must hold true regarding interest rates?
In a credible fixed exchange rate system, which condition must hold true regarding interest rates?
If the interest rate differential is not due to expected inflation differentials, what effect does this have on the expected future exchange rate?
If the interest rate differential is not due to expected inflation differentials, what effect does this have on the expected future exchange rate?
What must happen to inflation in a fixed exchange rate system to maintain the real interest rate between two countries?
What must happen to inflation in a fixed exchange rate system to maintain the real interest rate between two countries?
What is implied if the market expects a future depreciation of the currency that matches the requirements of the interest rate parity (IRP)?
What is implied if the market expects a future depreciation of the currency that matches the requirements of the interest rate parity (IRP)?
Under which condition can the only adjustment come from the spot exchange rate after a rate hike?
Under which condition can the only adjustment come from the spot exchange rate after a rate hike?
What does the concept of UIRP imply in a small open economy regarding future exchange rates?
What does the concept of UIRP imply in a small open economy regarding future exchange rates?
What is indicated when there is a shock resulting in i > i* and the expectation about the future exchange rate remains constant?
What is indicated when there is a shock resulting in i > i* and the expectation about the future exchange rate remains constant?
What is the primary condition for arbitrage in the exchange market to be effective?
What is the primary condition for arbitrage in the exchange market to be effective?
In the context of Uncovered Interest Rate Parity (UIRP), what does a higher interest rate in a country imply for its currency?
In the context of Uncovered Interest Rate Parity (UIRP), what does a higher interest rate in a country imply for its currency?
What does the expectations operator 'E' represent in the expected rate equation for UIRP?
What does the expectations operator 'E' represent in the expected rate equation for UIRP?
Which of the following formulations correctly represents the Uncovered Interest Rate Parity?
Which of the following formulations correctly represents the Uncovered Interest Rate Parity?
What are the main factors that can disrupt the application of Interest Rate Parity as a forecasting tool?
What are the main factors that can disrupt the application of Interest Rate Parity as a forecasting tool?
Which statement best describes the relationship established by Uncovered Interest Rate Parity?
Which statement best describes the relationship established by Uncovered Interest Rate Parity?
What does the equation $E_{t} riangle s_{t,t+1} = i_{t,t+1} - i_{t,t+1}^*$ express?
What does the equation $E_{t} riangle s_{t,t+1} = i_{t,t+1} - i_{t,t+1}^*$ express?
What can be inferred if the expected return on home bonds is greater than that of foreign bonds according to the UIRP?
What can be inferred if the expected return on home bonds is greater than that of foreign bonds according to the UIRP?
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Study Notes
Arbitrage in the Exchange Market
- Arbitrage in financial markets occurs when returns on the same financial assets differ between countries.
- This implies that the price of a currency is determined by the returns on assets in that country.
- For arbitrage to occur, there must be free capital flows, no transaction costs, and no restrictions on banking.
- The Uncovered Interest Rate Parity (UIRP) states that the change in the exchange rate should be equal to the difference in interest rates between two countries.
- This means that if the interest rate in one country is higher, the currency of that country should depreciate in the future.
- UIRP is used to understand the relationship between interest rates and exchange rates and predict future exchange rates.
- Problems with using UIRP as a forecasting tool include:
- It is difficult to determine which variable (spot rate or expected future exchange rate) should adjust.
- Expectations about future exchange rates are unobservable.
- UIRP has implications for fixed exchange rate systems:
- In a credible regime, interest rates must be equal across countries to maintain a fixed exchange rate.
- This implies that monetary policy is not independent.
- The UIRP can be used to analyze the impact of "transitory" shocks on exchange rates.
- UIRP is related to the Purchasing Power Parity (PPP) through the Fisher effect:
- The Fisher effect states that the nominal interest rate is equal to the real interest rate plus the expected inflation rate.
- If real interest rates are equal across countries, then changes in exchange rates are driven by expected inflation differentials.
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