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Peter Zeitz

Additional Notes on the Interest Parity Condition and Fixed Exchange Rates
Here are some notes on the uncovered interest parity condition and fixed exchange rates. At the
conclusion of the notes, I use link the material on fixed exchange rates to our discussion of net exports
using the Eurozone as an example.
The Exact and Approximated Uncovered Interest Parity Conditions
The uncovered interest parity condition says that the SGD return on an SGD investment should be the
same as the SGD return on a EUR investment. We will consider an example where the outcome deviates
from the interest parity condition.
Take the following information: the SGD interest rate ($ ) is 5%, the EUR interest rate ( )is 3%, the
current SGD/EUR exchange rate ( ) is 1.2 SGD per EUR, and the expected exchange rate one year from

now (+1
) is 1.25 SGD per EUR. Consider two possible investment options. Under option 1, we invest
SGD in an SGD account and earn the SGD interest rate. Call the expected rate of return under option 1
$ . Under option 2, we convert SGD to EUR, invest in a EUR account, and convert our EUR back to SGD at
the end of the year. Here, we earn the EUR interest rate plus an expected return through appreciation of
the EUR. Call the expected rate of return under option 2 . The two strategies are summarized in the
table below.

Option 1

Option 2

Right Now

One Year From Now

Invest 1 SGD in SGD


account at an interest
rate of 5%.
Trade 1 SGD for 1/1.2=
0.833 EUR
Invest 0.833 EUR in a
EUR account at an
interest rate of 3%

Withdraw 1*(1+0.05)=
1.05 SGD

Expected Rate of
Return
$ = 5.0%

Withdraw
0.833*(1+0.03)=
0.858 EUR

= 7.3%

Convert 0.858 EUR at


market exchange rate.
This is expected to be
1.25 SGD per EUR.

You expect this to yield


1.25 SGD per EUR
*(0.858 EUR )=
1.073 SGD
The exact formula for the expected rate of return on option 2 is shown in Equation 1.

+1
(1 + )
1

By rearranging terms, we can rewrite Equation 1 as shown below in Equation 2.

= +

+1

+1

+

Equation 2 breaks down the expected return on option 2, , into three additive components.
1) The rate of interest on the EUR deposit = 3.0%
2) The expected rate of EUR appreciation against the SGD
3) The product of and

+1

1.251.2
)
1.2

or (0.03) (

+1

1.251.2
1.2

= 4.167%

=0.125%

If we sum these three terms together, we get 7.3%. The third term is typically quite small relative to
terms (1) and (2), so it can be neglected without much loss of accuracy. Here, if we omit term (3), we
would get 7.2%.
In class, I introduced an approximation for based on dropping this third term. The approximation is
shown below in Equation 3.
+

+1

I emphasize this approximation because both of terms in Equation 3 have a relatively straightforward
interpretation. The more accurate version, Equation 2, includes another term that lacks a simple
interpretation.
The Uncovered Interest Parity Equation is an Arbitrage Condition
The uncovered interest parity condition says that arbitrage should cause to be equal to $ in
equilibrium. Lets think about how arbitrage would work to equalize expected returns using the example
of SGD and EUR investments described previously. We found that the expected return on SGD
investments was 3% and that the expected return on EUR investments was 7.2% (using our
approximation). If this were the case, investors holding SGD could benefit from selling their SGD
holdings and purchasing EUR. However, investors holding EUR would not be willing to purchase SGD at
the current exchange rate. To persuade EUR holders to sell, SGD holders would have to bid up the EUR
exchange rate until it satisfies the (approximate) interest parity condition shown in equation 4. This
implies a nominal depreciation of the SGD.
$ = +

+1

We can solve for the equilibrium exchange rate (expressed in SGD per EUR), by rearranging Equation 4,
as shown in Equation 5.
=

+1
$ + 1

Equation 5 also express the influence of changes in monetary policy on exchange rates. Holding

and +1
fixed, an increase in the SGD interest rate, $ , will cause a decrease in the equilibrium exchange
rate, . Since we have expressed as SGD per EUR, a decrease in is an appreciation of the SGD

against the EUR. Conversely, an increase in the EUR interest rate will cause a depreciation of the SGD
against the EUR (here, an increase in ).
Takeaway Point: Under flexible exchange rates, an increase in the domestic interest rate causes
appreciation of the domestic currency against the foreign currency. An increase in the foreign interest
rate causes depreciation of the domestic currency against the foreign currency.
Lack of Monetary Policy Autonomy Under Fixed Exchange Rates
Suppose that the Monetary Authority of Singapore (MAS) decides to peg the SGD to the EUR at a rate
, while at the same time allowing free convertibility of SGD into EUR and visa versa. Under a fixed
exchange rate regime, the MAS offers to trade at fixed rate (say is 1.2 SGD per EUR) with anyone who
wants to buy or sell SGD. The MAS backs up this offer with foreign exchange reserves in the form of
EUR-denominated government bonds. These reserves are foreign assets held by MAS. If investors expect

the peg to hold for the next year with 100% confidence, then +1
= . In other words, investors will
expect the SGD-EUR exchange rate one year from now to be equal to the current exchange rate. If we
substitute this expression into Equation 5 and cancel terms we find that $ = . This tells us that the
MAS must set the SGD interest rate equal to the EUR interest rate in order to maintain the peg. If the
EUR interest rate increases, the SGD interest rate must increase in lockstep or the SGD will tend to
depreciate, breaking the peg. If the EUR interest rate decreases, the SGD interest rate must decrease in
lockstep or the SGD will tend to appreciate, breaking the peg. In the context of a fixed exchange rate
regime, nominal depreciations of the domestic currency are referred to as devaluations. Nominal
appreciations are called revaluations.
What will happen if interest rates are persistently misaligned under a fixed exchange rate regime?
If the EUR interest rate increases above the SGD interest rate, investors will want to sell off their SGD
and purchase EUR from the MAS. Since EUR holders will not be willing to purchase SGD due to the lower
rate of return, the MAS will need to use foreign exchange reserves to fulfill this demand. If the interest
rate differential is maintained for a long period, MAS reserves of EUR-denominated bonds will
eventually be exhausted and SGD holders will have to turn to private markets to obtain EUR. To
purchases EUR on private markets, SGD holders must offer EUR holders a more favorable current
exchange rate than the official rate of 1.2 SGD per EUR. They will need to bid up the current SGD-EUR
exchange rate to a level above the expected future SGD-EUR exchange rate, so that the SGD is expected
to appreciate over time vs. the EUR. Specifically, they will need to offer a current exchange rate that
satisfies the interest parity condition. When the interest parity condition holds, the expected rate of
appreciation of the SGD will be equal to the difference in the EUR interest rate and the SGD interest
rate, and investors will be indifferent between SGD and EUR investments. In sum, the MAS will
ultimately have to devalue the SGD if it allows the SGD interest rate to fall below the EUR interest rate
for a prolonged period.
What happens if interest rates are misaligned over a shorter time horizon under a fixed exchange rate
regime?
In the previous example, an increase in the EUR interest rate above the SGD interest rate eventually led
to devaluation of the SGD. Lets consider the case where the EUR interest rate rises above the SGD
interest rate temporarily, but not long enough to exhaust foreign reserves. To see what happens here, it
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is useful to think of a global pool of savings being allocated to investments that yield the highest rate of
return. If the peg is expected to hold AND an interest rate differential exists, the return on EUR
investments will dominate the return on SGD investments. This will attract SGD savings to EUR
investments, causing a capital outflow in Singapore and a capital inflow in Europe. Singapore will tend to
run a current account surplus and the Eurozone will tend to run a current account deficit. We saw
above, however, that this cant go on forever. Eventually, the MAS would run out of foreign reserves,
the SGD would devalue and the capital outflow would stop. If the SGD interest rate instead exceeded
the EUR interest rate, the opposite process would occur. There would be a capital inflow into Singapore,
Singapore would tend to run a current account deficit, and Europe would tend to run a current account
surplus.
Putting things together: Examining Current Account Imbalances in the Eurozone
Prior to 1999, European countries utilized independent national currencies with flexible
exchange rates and maintained distinct national monetary and fiscal policies. This meant that current
account imbalances within the Eurozone could be resolved through exchange rate movements. Since
1999, Eurozone members have operated under a single currency and common monetary policy, but
retain independent fiscal policies. This has effectively fixed nominal exchange rates among European
countries at their 1999 levels. Lets look at how current account imbalances among member countries
can be addressed under this arrangement. Since net exports account for the bulk of the current account,
we will focus on trade surpluses and trade deficits as the source of imbalances.
Recall the determinants of net exports discussed in lecture and shown in Equation 6.
(, , ) =

(, )
+ ( , )

(, +, )
In Equation 6, the real exchange rate is defined as, =

Among Eurozone countries, the nominal

exchange rate E is fixed so that the real exchange rate can only change over time through differences in

inflation rates across member countries, i.e. changes in .


Lets consider net exports from the perspective of Germany. Germany has run persistent trade surpluses
and current account surpluses. German current account surpluses are politically controversial because
they imply trade deficits and current account deficits in other parts of the world, such as Southern
European countries. In fact, the European monetary authority has recently threatened Germany with a
fine as high as 0.1% of German GDP, if it fails to reduce its current account surplus. Many Southern
European countries are burdened by high-levels of external debt, persistent current account deficits,
and high levels of unemployment. A reduction in the German current account surplus would benefit
Southern European economies by allowing them to increase exports, run CA surpluses (necessary to
repay external debt), and absorb some of their unemployed in export industries.
Based on Equation 6, lets list possible mechanisms for a reduction in the German current account
surplus and discuss their potential downsides:

1) E: A breakup of the Eurozone and a return to independent currencies is necessary for


adjustments in E. Independent currencies would allow deficit countries in Southern Europe to
depreciate their nominal exchange rates. This would enhance Southern Europes export
competitiveness vis--vis Germany and reduce the German current account surplus.
Downside: The currency union facilitates economic integration among member states. A
breakup of the currency union is politically difficult and would probably lead to lower trade
volumes within Europe. Moreover, business contracts in Europe are based on an expectation
that Europe will remain a common currency zone in the near future. A breakup could be
profoundly disruptive to Euro economies and could cause some companies to suffer large,
unanticipated losses, while others would experience windfall gains. Likewise households could
suffer unexpected losses and windfalls as well.
2)

If German inflation exceeds inflation in Southern Europe for a prolonged period, this will lead

to real appreciation in Germany relative to Southern Europe. This would enhance Southern
Europes export competitiveness vis--vis Germany and reduce the German current account
surplus.
Downside: Adjustment through differences in inflation rates tends to be a slow process. To
speed this up, Germany would have to tolerate a period of high inflation. This could be
achieved, for example, if the German government pushes domestic firms to introduce large,
across-the-board wage increases. However, inflation is politically unpopular in Germany, even
more so than in other parts of the world. An alternative to inflation in Germany is deflation in
Southern Europe. Rather than nominal wage increases in Germany, we would have to have
nominal wage decreases in Southern Europe. This would address current account imbalances,
but would make already bad economic conditions in Southern Europe even worse. Naturally,
this solution is politically unpopular in Southern Europe.
3) Y: Germany could increase its demand for Southern European imports by increasing government
spending or cutting taxes. This would boost German domestic output (Y), reduce the German
current account surplus, and allow Southern European countries to move towards current
account surplus.
Downside: Budget deficits are politically unpopular in Germany. Germany is currently running a
budget surplus. Germany plans to maintain budget surpluses in order to prepare for future
declines in tax revenue and increases in expenditure needs associated with aging of the
population.
4) : Southern Europe could reduce its demand for German imports by reducing government
spending or increasing taxes. This would reduce Southern European output, , but allow
Southern European countries to move towards trade surplus and Germany to move towards
trade deficit.
Downside: This solution, while politically popular in Germany, is politically unpopular in Southern
Europe. Southern European countries already face very high unemployment rates. Austere fiscal
policies in Southern Europe would cause further increases in unemployment.

Relationship to the Asian Financial Crisis


Southern European countries face similar difficulties in closing their current account deficits as
Asian countries did in the mid to late 1990s. Referring to (1), Devaluations of Asian currencies
under fixed exchange rates in 1997 caused severe disruptions to financial contracts and these
disruptions worsened the Asian crisis. One could imagine a breakup of the Eurozone causing
similar problems. Looking at (4), austere fiscal policies imposed by the IMF worsened economic
conditions in Asia after the crises. These policies allowed Asian countries to reverse current
account deficits, but came at a cost of increased unemployment, lost output, and political
unrest. If we want to further the analogy, Germany can be thought of as playing a role similar to
the IMF in the mid to late 1990s. While Germans (and the IMF) are aware of the distress caused
by devaluations and fiscal austerity in crisis countries, they do not want to be in the position of
perpetually bailing out these countries either. Finally, the question of who is at fault in both
cases is ambiguous. A current account surplus must always imply current account deficit
somewhere else in the world. Southern Europe cannot be said to be wholly responsible for
current account deficits. Southern European countries could not run these deficits unless other
countries, such as Germany, ran current account surpluses. Surplus countries tend to blame
imbalances on profligate policies adopted in deficit countries (e.g. budget deficits). Deficit
countries tend to blame imbalances on mercantilist policies adopted in surplus countries (e.g.
budget surpluses, undervalued exchange rates).