IFE Economics Coursework - 825 Words

International Fisher Effect Economics (Coursework Sample) Content: IFE EconomicsNameInstitutionThe IFE (International Fisher Effect) is an exchange rate model that was developed in the 1930s. This model is based on both present and future rates, and is used to understand the future projections of currency prices. These nominal rates, which are used to predict future currency movements, are risk-free. The IFE model needs to always work in its purest form and hence there is need for the risk-free interest rates to be free flowing between countries that share currency (Madura, 2011). Pure interest rates are used instead of inflation rates in this model because Irving Fisher, the economist who developed the model, made the assumption that excepted inflation rates do not affect real interest rates. This is because market arbitrage equalizes the two factors over time. According to the IFE, a country with a higher nominal rate than another will have its currency lose value. For example, if the interest rate in Britain is 7% and it is 5% in the United States whereas the GBP/USD exchange rate is 1.5, Great Britain is likely to see its currency depreciate in the future. A ratio of the foreign to domestic interest rates multiplied by the spot rate show the future spot rates for each country. The purchasing Power Polarity (PPP) is a theory, which states that the domestic purchasing powers of different currencies are always at equilibrium with their exchange rates. According to this theory therefore, an item would cost the same in two different countries with different currencies once the exchange rate is taken into account. Here is an example: suppose that the USSD is exchanging against the Mexican Pesos (MXN) for ten of these Pesos. In the United States, a soccer ball sells at $40 while it goes for 150 pesos in Mexico (Cashin McDermott, 2001).According to the exchange rate, this ball would be selling in Mexico at an equivalent of $15.american consumers interested in purchasing soccer balls would therefore be interested i n buying the commodity in Mexico than in the United States. In the event that consumers go with this trend, the following is likely to happen. First, the American consumers would need to exchange their dollars for pesos in order to buy the soccer balls in Mexico. In this case, the peso will become more valuable in relation to the dollar. Secondly, demand for soccer balls in the United States will decrease significantly causing the price of this commodity to decrease. Thirdly, demand for soccer balls in the Mexican market will increase causing an increase in their prices. Eventually, the prices and exchange rates in the two countries will change until there is purchasing power parity. The effect of money growth can be evident in many factors including prices of commodities and services as well as salaries and wages. A rise in money growth increases demand hence bringing about inflation. In a four quadrant graph, the first quadrant would represent the IS relationship whereas the secon d one would represent the aggregate demand. This is the relationship between the rate of inflation with and the money growth rate. The third quadrant would have 45-degree line to represent the movement of inflation rate to the horizontal axis, down from the vertical axis. The fourth and last quadrant would represent the reaction of the central bank to the effects caused by the rise in money growth in the United States. When the reaction of the central bank is based only on the rate of inflation, then the interest rate would appear as a constant from the IS curve of the graph. There can therefore be a representation for the central banks monetary policy MP in the first quadrant. The intersection of the IS curve with the interest rate would therefore determine growth in demand in the first quadrant. The assumption of flexible prices states that wages or salaries as well as prices of commodities are flexible. This assumption has been conveniently, and appropriately used by economists t o analyze the economy. In a flexible price model, the price of a commodi... IFE Economics Coursework - 825 Words International Fisher Effect Economics (Coursework Sample) Content: IFE EconomicsNameInstitutionThe IFE (International Fisher Effect) is an exchange rate model that was developed in the 1930s. This model is based on both present and future rates, and is used to understand the future projections of currency prices. These nominal rates, which are used to predict future currency movements, are risk-free. The IFE model needs to always work in its purest form and hence there is need for the risk-free interest rates to be free flowing between countries that share currency (Madura, 2011). Pure interest rates are used instead of inflation rates in this model because Irving Fisher, the economist who developed the model, made the assumption that excepted inflation rates do not affect real interest rates. This is because market arbitrage equalizes the two factors over time. According to the IFE, a country with a higher nominal rate than another will have its currency lose value. For example, if the interest rate in Britain is 7% and it is 5% in the United States whereas the GBP/USD exchange rate is 1.5, Great Britain is likely to see its currency depreciate in the future. A ratio of the foreign to domestic interest rates multiplied by the spot rate show the future spot rates for each country. The purchasing Power Polarity (PPP) is a theory, which states that the domestic purchasing powers of different currencies are always at equilibrium with their exchange rates. According to this theory therefore, an item would cost the same in two different countries with different currencies once the exchange rate is taken into account. Here is an example: suppose that the USSD is exchanging against the Mexican Pesos (MXN) for ten of these Pesos. In the United States, a soccer ball sells at $40 while it goes for 150 pesos in Mexico (Cashin McDermott, 2001).According to the exchange rate, this ball would be selling in Mexico at an equivalent of $15.american consumers interested in purchasing soccer balls would therefore be interested i n buying the commodity in Mexico than in the United States. In the event that consumers go with this trend, the following is likely to happen. First, the American consumers would need to exchange their dollars for pesos in order to buy the soccer balls in Mexico. In this case, the peso will become more valuable in relation to the dollar. Secondly, demand for soccer balls in the United States will decrease significantly causing the price of this commodity to decrease. Thirdly, demand for soccer balls in the Mexican market will increase causing an increase in their prices. Eventually, the prices and exchange rates in the two countries will change until there is purchasing power parity. The effect of money growth can be evident in many factors including prices of commodities and services as well as salaries and wages. A rise in money growth increases demand hence bringing about inflation. In a four quadrant graph, the first quadrant would represent the IS relationship whereas the secon d one would represent the aggregate demand. This is the relationship between the rate of inflation with and the money growth rate. The third quadrant would have 45-degree line to represent the movement of inflation rate to the horizontal axis, down from the vertical axis. The fourth and last quadrant would represent the reaction of the central bank to the effects caused by the rise in money growth in the United States. When the reaction of the central bank is based only on the rate of inflation, then the interest rate would appear as a constant from the IS curve of the graph. There can therefore be a representation for the central banks monetary policy MP in the first quadrant. The intersection of the IS curve with the interest rate would therefore determine growth in demand in the first quadrant. The assumption of flexible prices states that wages or salaries as well as prices of commodities are flexible. This assumption has been conveniently, and appropriately used by economists t o analyze the economy. In a flexible price model, the price of a commodi...