TERM 1- Credits 3 (Core)

Prof Madhu & Prof Rajasulochana

TAPMI, Manipal
Session 17

Key Topics
Theories: PPP and IRP
Mundell Fleming Model
IS curve
LM curve
BP Curve

Theories of Exchange Rate Determination

The law of one price

The law of one price states
Identical products sold in different countries must sell for one price if their
price is expressed in one currency
Assumptions:
Competitive markets
No transportation costs; no trade barriers

The law of one price..

Goods Market

Asset Market

Purchasing Power Parity (PPP)

Theory

Interest Rate Parity (IRP) Theory

Purchasing Power Parity (PPP) Theory

The PPP theory states that price of identical goods
and services should be equal at home and abroad.
Absolute Version:
= .
Relative Version:

Interest Rate Parity (IRP) Theory

States that arbitrage under perfect mobility of funds will ensure
equality of return on currencies.
i.e, r = r* +
Where r =domestic interest rate
r* = foreign interest rate
= expected depreciation of domestic currency

IRP Contd..
For an investor from India, there are two comparable investment options:
returns from risk less Indian bonds of 1 year maturity = (1+r)
returns from risk less Foreign bond of 1 year maturity=(1+r*)
But he invests todays ER , that is , E.
He gets turn after a year, that is,
For the investor to be indifferent between the two options,
r = r* +( - E)/E
If INR depreciates, > E and the second term is positive( forward premium)
If INR appreciates, < E and the second term is negative (forward discount)

IRP Contd..
Summary:
Interest Rate Parity states:
Higher interest rates on a currency offset by forward discounts.
Lower interest rates are offset by forward premiums.

IS-LM Model in an Open Economy

Mundell-Fleming model

How different is an open economy different

from a closed one?
An open economy is influenced by trade and finance channels.
Current A/C includes Net Exports ( X-M)
= + x , where is autonomous exports and induced exports
is a positive function of real exchange rate, .
= , where import is a positive function of real GDP.
Together, =(, )

Contd..
Capital A/C accounts for net capital flows, i.e, = ( )
Here is exogenously given foreign interest rate.
The exchange rate expectations are assumed to be static.
If > NKI is positive and vice versa.

Contd..
BOP = NX +NKI
BOP = +x + ( ) = IR
Under flexible ER, the market forces ensure = . Hence, IR = 0
Therefore, the forex market is in equilibrium when,
+ x + ( ) = 0
Solving for ,
x = ( )
=

+ ( x )

Mundell-Fleming Model
Assumptions
1. Perfect Capital Mobility any difference in the interest rates across
countries causes capital inflows of infinite flows. The BOP curve
becomes horizontal at = *
2. The domestic price level is constant
3. Spot and forward exchange rates are identical, and the existing
exchange rates are expected to persist indefinitely
4. The balance of trade depends only on income and the exchange rate

Capital Mobility
High degree of integration among financial markets markets in
which bonds and stocks are traded
the assumption of perfect capital mobility
Capital is perfectly mobile internationally when investors can purchase in any
country they choose quickly, with low transaction costs , and in unlimited
amounts
Under this assumption, asset holders are willing and able to move large
amounts of funds across borders in search of the highest return or lowest
borrowing cost

New IS curve
Y = AD = C + I + G + NX
Y = AD = a + c (Y - )+ b- di + + +x
Y - cY + zY = (a - c + b + + ) - di +x
Y* =

1
(1+)

+ x

For a given real exchange rate we draw an IS curve

LM curve
For the money market to be in equilibrium, Ms must equal Md:

M
kY hi
P
Solving for i:
1
M
i kY

h
P

IS LM model in an open economy

Considers equilibrium in three markets: Goods market, asset market and
exchange market.So we have three equations:
IS curve:Y* =

1
(1+)

+ x

LM curve: i 1 kY M
h

BP curve: i = i*
It has three unknowns: , Y and
The equilibrium interest rate is always determined by the BP curve

IS-LM-BP Model
Interest
Rate

LM

BP Curve

i*

IS
Y*

Income, Output