Hows is uncovered interest rate parity related to inflation? The equation is E(s1)/s0 = (1+ rFc)/(1+rDc) Is it because nominal rate is product of real rate and inflation? Why it is called as uncovered interest rate parity? I also did not understand the explanation that it is derived from PPP. Is it relative purchase parity? ----------------- Which of the following economic concepts links inflation and interest rates to exchange rates? A) International Fisher relation. B) Relative purchasing parity (PPP). C) Uncovered interest Rate Parity. D) Balance of payments. Your answer: A was incorrect. The correct answer was C) Uncovered interest Rate Parity. Combining PPP and the international Fisher relation, results in the theory of uncovered interest rate parity, which links spot exchange rates, expected spot exchange rates, and nominal interest rates. The international Fisher relation relates nominal interest rates to inflation, while relative PPP links exchange rates to inflation. Only the theory of uncovered interest rate parity links interest rates, inflation rates and exchange rates together.
the explanation there i think is actually pretty good. take a look at the formula for international fisher, then look at PPP, now compare it to uncovered. in international fisher you have the 1+Rfc/1+Rdc = 1 + E(ifc)/1+E(idc) PPP you have E(St)/So = (1 + E(ifc))^t/1+E(idc)^t what uncovered interest rate parity does is combine those 2. so instead of with the int fisher you linking up nominal interest rates w/ inflation or in PPP you liking up exchange rates with inflation, by substituting those formulas around, uncovered int rate parity then gives you all of the pieces- linking interest rates, inflation, and exchange rates together. hope that helps a bit- lay the 3 formulas out side by side and maybe it makes a bit more sense?
The difference between covered and uncovered IRP is this: Covered IRP: Forward = Spot *(1+ RFR domestic) / (1 + RFR Foreign) Uncovered IRP: Expected Spot = Spot *(1+ RFR domestic) / (1 + RFR Foreign) So basically one determins forward rates and the other determines expected future spot rates. In that question only C has these three linked.
banny, can you please clarify this. I’m always thrown off about whether to use nominal rates or real rates in the covered and uncovered IRP. Do you know which one we are supposed to use as rDC and rFC?
Nominal. Fisher relation assumes all real interest rates are equal and steady. That is the whole point of it…nominal interest rate differentials are caused by inflation differentials only. Nominal rates are used in all parity relations.
Excellent. Thanks for explaining very well.
You guys are really getting good. Looking really promising for the exam.