Economics
Exchange rates as prices
Level II tests the parity relationships as a linked set. Covered interest rate parity is a no-arbitrage identity: F/S = (1 + r_price currency)/(1 + r_base currency). If the foreign interest rate exceeds the domestic rate, the foreign currency trades at a forward discount. Uncovered interest rate parity replaces the forward with the expected future spot rate and does not hold reliably - that gap is the carry trade. Relative purchasing power parity links inflation differentials to expected currency change; the international Fisher effect combines PPP with the Fisher equation.
Policy and growth
Monetary transmission, inflation targeting, and the Taylor rule; fiscal multipliers and crowding out. Growth accounting in a Cobb-Douglas framework, convergence in the neoclassical model, and endogenous growth driven by human capital, technology, and institutions. Regulation: externalities, information asymmetry, regulatory capture, and cost-benefit analysis.
Traps
- Covered interest parity holds by arbitrage; uncovered parity is an equilibrium condition that often fails.
- Real exchange rate changes require adjusting nominal changes for relative inflation.
- A high nominal interest rate currency is expected to depreciate - not a free lunch.
Worked example
Spot USD/EUR is 1.20, the one-year USD rate is 3%, and the one-year EUR rate is 1%. The one-year forward is 1.20 x (1.03/1.01) = 1.2238 USD/EUR. The euro trades at a forward premium of about 1.98%, exactly offsetting the interest differential, so an investor borrowing dollars to fund euro deposits earns zero hedged excess return.
Rule of thumb: run parity as forward divided by spot, minus one, equal to the interest differential. Any residual implies arbitrage.