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IFM Chapter 08

Chapter 8 discusses the relationships between inflation, interest rates, and exchange rates, focusing on Purchasing Power Parity (PPP) and the International Fisher Effect (IFE). PPP suggests that currency values are influenced by inflation differentials, while IFE relates exchange rates to interest rate differentials, indicating that higher interest rates may lead to currency depreciation. Both theories face challenges in consistent application due to market imperfections and other influencing factors.

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10 views

IFM Chapter 08

Chapter 8 discusses the relationships between inflation, interest rates, and exchange rates, focusing on Purchasing Power Parity (PPP) and the International Fisher Effect (IFE). PPP suggests that currency values are influenced by inflation differentials, while IFE relates exchange rates to interest rate differentials, indicating that higher interest rates may lead to currency depreciation. Both theories face challenges in consistent application due to market imperfections and other influencing factors.

Uploaded by

walijoy341
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Chapter 8:

Relationships Between Inflation,


Interest Rates, and Exchange
Rates
Purchasing Power Parity (PPP)

• When one country’s inflation rate rises


relative to that of another country,
decreased exports and increased imports
depress the country’s currency.
• The theory of purchasing power parity
(PPP) attempts to quantify this inflation -
exchange rate relationship.
Interpretations of PPP

• The absolute form of PPP, or the “law of


one price,” suggests that similar products
in different countries should be equally
priced when measured in the same
currency.
Interpretations of PPP

• The relative form of PPP accounts for


market imperfections like transportation
costs, tariffs, and quotas.
• This version acknowledges that because
of these market imperfections, prices of
the same basket of products in different
countries will not necessarily be the same
when measured in a common currency.
Rationale behind PPP Theory

Suppose U.S. inflation > U.K. inflation.


  U.S. imports from U.K. and  U.S.
exports to U.K., so £ appreciates.
This shift in consumption and the
appreciation of the £ will continue until
 in the U.S., priceU.K. goods  priceU.S. goods, &
 in the U.K., priceU.S. goods  priceU.K. goods.
Formula of PPP

ef = (1 + Ih ) – 1
(1 + If )
 If Ih > If , ef > 0 (foreign currency appreciates)
If Ih < If , ef < 0 (foreign currency depreciates)

If Ih = 5% & If = 3%, ef = 1.05/1.03 – 1 = 1.94%

So, foreign currency should appreciate by


roughly 2%.
Simplified PPP Relationship

• When the inflation differential is small, the


PPP relationship can be simplified as
ef  Ih _
If

• Suppose IU.S. = 9%, IU.K. = 5%. Then PPP


suggests that e£  4%.
Graphic Analysis of Purchasing Power Parity
Inflation Rate Differential (%)
home inflation rate – foreign inflation rate
4
PPP line

-3 -1 1 3 %  in the
foreign
currency’s
-2 spot rate

-4
Graphic Analysis of Purchasing Power Parity
Inflation Rate Differential (%)
home inflation rate – foreign inflation rate
4
PPP line
Increased
purchasing
power of
foreign 2
goods

-3 -1 1 3 %  in the
Decreased foreign
purchasing currency’s
-2 power of spot rate
foreign
goods
-4
Testing the PPP Theory

Conceptual Test
• Plot the actual inflation differential and
exchange rate % change for two or more
countries on a graph.
• If the points deviate significantly from the
PPP line over time, then PPP does not
hold.
Testing the PPP Theory

• Empirical studies indicate that the


relationship between inflation differentials
and exchange rates is not perfect even in
the long run.
Why PPP Does Not Occur
PPP may not occur consistently due to:
 confounding effects:
Why PPP Does Not Occur

 lack of substitutes for traded goods:


• The idea behind PPP theory is that as soon as
the prices become relatively higher in one
country, consumers in the other country will
stop buying imported goods and shift to
purchasing domestic goods instead. This shift
influences the exchange rate. But, if substitute
goods are not available domestically,
consumers may not stop buying imported
goods.
International Fisher Effect (IFE)

• Along with PPP theory, another major


theory in international finance is the
international Fisher effect (IFE) theory. It
uses interest rate rather than inflation rate
differentials to explain why exchange
rates change over time, but it is closely
related to the PPP theory because interest
rates are often highly correlated with
inflation rates.
International Fisher Effect (IFE)

• According to the Fisher effect, nominal


risk-free interest rates contain a real rate
of return and an anticipated inflation.
• According to PPP, exchange rate
movements are caused by inflation rate
differentials.
International Fisher Effect (IFE)

• The international Fisher effect (IFE) theory


suggests that currencies with higher interest
rates will depreciate because the higher rates
reflect higher expected inflation.
• Hence, investors hoping to capitalize on a
higher foreign interest rate should earn a
return no better than what they would have
earned domestically (uncovered investment).
Derivation of the IFE

• We Know that

ef = (1 + ih ) _ 1 [similar to IRP]
(1 + if )
 If ih > if , ef > 0 (foreign currency appreciates)
If ih < if , ef < 0 (foreign currency depreciates)

If ih = 8% & if = 9%, ef = 1.08/1.09 – 1 = - .92%


 This will make the return on the foreign
investment equal to the domestic return.
Derivation of the IFE

• When the interest rate differential is small,


the IFE relationship can be simplified as
ef  ih _
if
• If the British rate on 6-month deposits were
2% above the U.S. interest rate, the £ should
depreciate by approximately 2% over 6
months. Then U.S. investors would earn
about the same return on British deposits
as they would on U.S. deposits.
Graphic Analysis of the International Fisher Effect
Interest Rate Differential (%)
home interest rate – foreign interest rate
4
Lower
returns from IFE line
investing in
foreign 2
deposits

-3 -1 1 3 %  in the
foreign
Higher currency’s
returns from spot rate
-2 investing in
foreign
deposits
-4
Graphic Analysis of the IFE

• The point of the IFE theory is that if a firm


periodically tries to capitalize on higher
foreign interest rates, it will achieve a yield
that is sometimes above and sometimes
below the domestic yield.
• On the average, the firm would achieve a
yield similar to that by a corporation that
makes domestic deposits only.
Tests of the IFE

• If the actual points of interest rates and


exchange rate changes are plotted over
time on a graph, we can see whether the
points are evenly scattered on both sides
of the IFE line.
• Empirical studies indicate that the IFE
theory holds during some time frames.
However, there is also evidence that it
does not consistently hold.
Why the IFE Does Not Occur

• Since the IFE is based on PPP, it will not


hold when PPP does not hold.
• For example, if there are factors other than
inflation that affect exchange rates, the
rates will not adjust in accordance with
the inflation differential.
Comparison on IRP, PPP & IFE
Theory Key Variables Summary

Interest rate Forward rate Interest differential The forward rate of one currency with respect to
party (IRP) premium or another will contain a premium or discount that is
discount determined by the differential in interest rates
between the two countries. As a result, covered
interest arbitrage will provide a return that is no
higher than a domestic return.

Purchasing Percentage change Inflation rate The spot rate of one currency with respect to
Power Parity in spot exchange differential another will change in reaction to the differential
(PPP) rate in inflation rates between the two countries.
Consequently, the purchasing power for
consumers when purchasing goods in their own
country will be similar to their purchasing power
when importing goods from the foreign country.

International Percentage change Interest rate The spot rate of one currency with respect to
Fisher Effect in spot exchange differential another will change in accordance with the
(IFE) rate differential in interest rates between the two
countries. Consequently, the return on uncovered
foreign money market securities will, on an
average, be no higher than the return on
domestic money market securities from the
perspective of investors in the home country.

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