Critically evaluate the concepts of the uncovered interest parity and Essay

Critically evaluate the concepts of the uncovered interest parity and covered interest parity conditions in explaining changes in exchanges rates. Discuss their - Essay Example The principal function of FEM is the transfer of funds or purchasing power from one country or currency to another. When we consider exchange rate determination, the factors that significantly concern time dependence, become extremely important. It is somewhat reflected in the interest rates which themselves are prices of present-future substitution (abstinence); this influences savings, consumption, demand for goods, and so, money (both domestic and foreign) and hence the related prices. Thus exchange rate being a price of foreign currency in terms of the domestic currency, becomes influenced by interest rate and inflation over time. The sections below are titled along sub-themes with a critical note at the concluding section. As stated above, the exchange rate is in turn governed by a currency's interest rate and hence the question of parity and differentials become extremely important. Interest rate parity is said to occur when deposits of all currencies offer the same expected return. Two types of such parity have been envisaged in the literature Covered and uncovered that we discuss below. In the floating exchange rates regime exchange rates are market determined. Since Early Mundell-Flemming days (i.e. early nineteen sixties), it has been established that the degree of capital mobility is crucial in determining the open economy macroeconomics of participating countries. In this context when perfect international capital mobility occurs, bonds that are free of default risk domestically become free of default risk internationally also. With capital mobility of this degree, domestic bonds become perfect substitutes of foreign bonds on which forward cover has been taken and arbitrage brings about equality between domestic interest rate i and foreign interest rate i* plus the forward premium on foreign exchange 'f '.This is covered interest rate parity (cip) given by : i = i* + f (1) 2.2 Uncovered Interest Parity A stronger definition of capital mobility incorporates additional criterion that attitude towards exchange risk be taken as risk neutrality because that is nearly common among investors and exchange risk is perfectly diversifiable. In that case speculation turns the forward premium into equality with the expected rate of appreciation of the foreign currency: f = [(Et+1 - Et) / Et]e (2) where E is the exchange rate that the price of the foreign currency in terms of domestic currency (superscript e refers to expected status of the associated variable).Then equation (1) changes into i = i* + [(Et+1 - Et) / Et]e (3) This is the condition known as uncovered interest parity (uip). 3. Relationship between Covered and Uncovered Interest Parity In the case of perfect foresight and perfect capital mobility the two conditions will be the same. The relationship between the two lies in the characteristic of future expectation orientation of the uip that one does not take care of in the perfect capital mobility, perfect information and perfectly rational expectations. Form empirical standpoint,