Microeconomics Essay Example | Topics and Well Written Essays - 500 words - 19

Microeconomics - Essay Example The exchange rate at which the two currencies will be exchanging in the forward contract at the preset future date is fixed and thus the investor is saved from the risk of adverse exchange rate movements. This method eliminates the downside risk but also puts a cap on the profits that could have been received if the exchange rate moved favourably instead of unfavourably. The Purchasing Power Parity is an important concept which links prices, exchange rates and inflation. ‘Three versions of PPP have traditionally been used in the literature.’ (Clark, Bartolini, Bayoumi & Symansky, 1994) These versions include the law of one price, absolute PPP and relative PPP. ‘In relative terms, PPP says that exchange rate move in line with the interest rate differential.’ (Rochon & Vernengo, 2001) On the long-term basis, the lower the inflation the more the currency appreciates and the higher the rate of inflation the greater is the magnitude of the currency’s depreciation. In terms of the of the Ireland and US, the exchange rate went down from $1/â‚ ¬0.70 to $1/â‚ ¬0.65 for the US dollar indicating the depreciation of US dollar in terms of Euro and hence signalling inflation in the US market. On the other side of the picture an appreciation of the Euro signifies low inflation and high growth in the Irish market. In terms of the goods the US dollar could buy â‚ ¬ 0.7 worth of goods one year back and now it can afford only â‚ ¬ 0.65 for the same dollar. Thus the US dollar depreciated indicating inflation in the US market and showing an appreciation of the