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Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors compare interest rates available on bank deposits in two countries. [1] The fact that this condition does not always hold allows for potential opportunities to earn riskless profits from covered interest arbitrage .
The effect estimates future exchange rates based on the relationship between nominal interest rates. Multiplying the current spot exchange rate by the nominal annual U.S. interest rate and dividing by the nominal annual U.K. interest rate yields the estimate of the spot exchange rate 12 months from now:
The formal model underlying the hypothesis is the uncovered Interest Rate Parity condition which states that in absence of a risk premium, arbitrage will ensure that the depreciation or appreciation of a country's currency vis-à-vis another will be equal to the nominal interest rate differential between them. Since under a peg, i.e. a fixed ...
The nominal interest rate is the accounting interest rate – the percentage by which the amount of dollars (or other currency) owed by a borrower to a lender grows over time, while the real interest rate is the percentage by which the real purchasing power of the loan grows over time. In other words, the real interest rate is the nominal ...
Relative Purchasing Power Parity is an economic theory which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is a dynamic version of the absolute purchasing power parity theory. [1] [2]
In a system of fixed exchange rates, central banks announce an exchange rate (the parity rate) at which they are prepared to buy or sell any amount of domestic currency. Thus net payments flows into or out of the country need not equal zero; the exchange rate e is exogenously given, while the variable BoP is endogenous.
The key features of the model include the assumptions that goods' prices are sticky, or slow to change, in the short run, but the prices of currencies are flexible, that arbitrage in asset markets holds, via the uncovered interest parity equation, and that expectations of exchange rate changes are "consistent": that is, rational.
The Balassa–Samuelson effect, also known as Harrod–Balassa–Samuelson effect (Kravis and Lipsey 1983), the Ricardo–Viner–Harrod–Balassa–Samuelson–Penn–Bhagwati effect (Samuelson 1994, p. 201), or productivity biased purchasing power parity (PPP) (Officer 1976) is the tendency for consumer prices to be systematically higher in more developed countries than in less developed ...