185 summer 2004

Exchange Rates

In our brief discussion of exchange rates we will consider how exchange rates link the goods markets and bond markets in two countries.

Purchasing Power Parity links the two goods markets.

Interest Rate Parity links the two bond markets.

The idea is that exchange rates and interest must somehow adjust to eliminate arbitrage profits.

Suppose we started in balance with no arbitrage profit opportunities.

Increasing the Canadian interest rate to 10% could have the effect of raising the value of the Canadian dollar to shut off the possibility of arbitrage profits.