Openness in financial markets

Exchange rate equals relative price levels

- $P = SP*$
- Composite of the prices of all commodities entering into the reference basket
- If LOOP holds for every commodity, PPP must hold too as long as RBs are identical

- Trade barriers, nontradables and pricing to market affect the accuracy of PPP
- LOOP does not perform well also

Higher markup is likely to be put over the marginal cost

- Price of foreign currency in terms of domestic currency
- Appreciation of domestic currency means a decrease in S
- Depreciation of domestic currency means an increase in S

- Price of foreign goods in terms of domestic goods
- $Q=\frac{SP*}{P}$ where P and P* are price index of domestic and foreign goods
- Real appreciation corresponds to a decrease in Q
- Real depreciation corresponds to an increase in Q

- Arbitrage Condition
- Assume financial investors want to hold the bond with the highest expected return
- For both UK and UK bonds to be held, they have to have the same expected rate of return
- $1 + i_{t+1} = \frac{S^e_{t+1}}{S_t}(1 + i^*_{t+1})$ (ignoring risks and transaction costs)
- Good assumption for countries with developed financial markets and few capital controls
- The expected rate of return for holding UK and US bonds must be equal.

Price levels in different countries are not equal

There is no reason to believe that price levels in different countries are equal

- Assume competitive market, free of transportation costs and trade barriers
- Identical goods sold in different contries must sell for the same price when prices are expressed in a common currency
- $P_i = SP^*_i$ where $P_i$ is the domestic price of good $i$ in domestic currency
- $P^*_i$ is the forein price of good $i*$ in foreign currency

Equalizing the purchasing power of different currencies

- Financial investors choose whether to hold domestic assets or foreign assets
- People hold money to engage in transactions: the relevant choice is between domestic interest-paying assets and foreign interest-paying assets