Chapter Summaries 5, 6, 7, and 8

Chapter 5: Interest Rate Parity

Interest rate parity theory shows that decisions and actions of international investors cause movements or changes in the exchange rates in a country. This theory is based on the assumption that transactions in the financial account of a country cause movements in the exchange rate. This indicates a deviation in purchasing power parity theory which argues that transactions in the current account of a country cause changes in the exchange rates.

Endogenous variables in IRP model are currency quantity and exchange rate in a market. They include interest rates in Britain and US as well as the anticipated exchange rates. Comparative statics provide an estimate of the impact that exogenous variables have on endogenous variables. If interest rates in US increase, dollar appreciates while British pound depreciates. This also applies for interest rates in Britain.

Equilibrium exchange rates are sometimes determined using graphical approach. In such a case, foreign and domestic return rates are plotted against the exchange rates. Vertical line is used to represent domestic return rate because it does not depend on exchange rate. Foreign exchange and exchange rates are negatively related. Equilibrium rate of exchange if found at the intersection of these rates. Exchange rate acts as the most important endogenous variable in IPR model.

Chapter 6: Purchasing Power Parity

Purchasing power parity or PPP refers to a tool that determines the comparing costs and exchange rates of services and goods among countries. This theory attributes changes in the exchange rates to transactions in the current account of a country. On the other hand, theory of interest rate parity considers transactions in capital account a major cause of changes in the exchange rates. PPP theory is based on single price principle.

Average price of items in a country is given by consumer price index (CPI) in relation to the base year. Price changes are tracked using average basket of the market. This basket contains the average amounts of commodities purchased by households. Thus, CPI estimates cost of average basket in the market.

Chapter 7: Interest Rate Determination

Supply of money in a country is controlled by the central bank via the operations of an open market that involves buying or selling treasury bonds. Desire to buy services and goods as well as assets’ interest rates determine money demand. Equilibrium of the interest rate in a country is achieved through the interaction of money demand and supply. Interest rates are important in a country’s foreign exchange because they influence the assets’ rate of return.

Money does not include currency and coins value only. It also includes total value of the deposits of checking accounts. As different financial institutions try to earn more profits, interest rates for deposits and loans vary.

Money is used largely as an exchange medium, account unit, and store of the value of assets. Money supply is measured as M1, M2 and M3. M1 refers to liquid assets, M2 consists of the M1 assets and others including money in deposits accounts and savings. Other M2 assets include mutual funds and short time deposits. M3 refers to the assets in M2 and others such as repurchase liabilities and large-denomination deposits.

Chapter 8: National Output Determination

Supply of services and goods determines the national output’s equilibrium level. According to the Keynesian market model, quantity of national output is determined by the demand for the output. Exchange rate is related negatively to the equilibrium GNP. Consumption demand refers to amount of services and goods demanded by households and individuals. This quantity depends on the disposable income. Government demand is an exogenous variable and it represents the amount of services and goods demanded by the government.