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Inflation, Interest Rates, and Exchange Rates

This chapter discusses three theories related to inflation, interest rates, and exchange rates: 1) Purchasing power parity (PPP) theory states that inflation rate differentials between countries should equal the change in the exchange rate. 2) International Fisher effect (IFE) theory suggests that interest rate differentials between countries should equal expected inflation differentials and influence exchange rate changes. 3) Interest rate parity (IRP) theory from the previous chapter states that interest rate differentials should equal expected exchange rate changes. The chapter compares these theories and includes exhibits showing relationships between inflation, interest rates, and exchange rates for major currencies.

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32 views15 pages

Inflation, Interest Rates, and Exchange Rates

This chapter discusses three theories related to inflation, interest rates, and exchange rates: 1) Purchasing power parity (PPP) theory states that inflation rate differentials between countries should equal the change in the exchange rate. 2) International Fisher effect (IFE) theory suggests that interest rate differentials between countries should equal expected inflation differentials and influence exchange rate changes. 3) Interest rate parity (IRP) theory from the previous chapter states that interest rate differentials should equal expected exchange rate changes. The chapter compares these theories and includes exhibits showing relationships between inflation, interest rates, and exchange rates for major currencies.

Uploaded by

Feriel El Ilmi
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

Relationships among Inflation,

Interest Rates, and Exchange


Rates
Chapter 8
Relationships among Inflation,
Interest Rates and Exchange Rates
 Chapter Objectives
This chapter will:
A. Explain the purchasing power parity (PPP) theory and its
implications for exchange rate changes
B. Explain the International Fisher effect (IFE) theory and its
implications for exchange rate changes
C. Compare the PPP theory, the IFE theory, and the theory
of interest rate parity (IRP), which was introduced in the
previous chapter
Purchasing Power Parity (PPP)
1. Interpretation of Purchasing Power Parity
a. Absolute Form of PPP: without international barriers,
consumers shift their demand to wherever prices are
lower. Prices of the same basket of products in two
different countries should be equal when measured in
common currency
b. Relative Form of PPP: Due to market imperfections
(transportation costs, tariffs, and quotas), prices of the
same basket of products in different countries will not
necessarily be the same when measured in a common
currency. However, the rate of change in prices should
be somewhat similar when measured in common
currency as long as transportation costs and trade
barriers are unchanged
Purchasing Power Parity
1. Relationship between relative inflation
rates (I) and the percentage change in the
foreign currency (ef).
1 Ih
ef  1
1 I f

2. Simplified PPP relationship


e f  Ih  I f
Exhibit 8.1 Summary of Purchasing
Power Parity
Exhibit 8.2 Illustration of Purchasing Power
Parity
Exhibit 8.3 Identifying Disparity in
Purchasing Power
Testing the Purchasing Power Parity
Theory
1. Conceptual tests of PPP
2. Statistical Test of PPP
3. Results of Tests of PPP
4. Tests of PPP for each currency
5. Limitation of PPP Tests
Exhibit 8.4 Comparison of Annual Inflation
Differentials and Exchange Rate Movements For Four
Major Currencies
Why Purchasing Power Parity Does
Not Occur
1. Confounding effects
2. No substitutes for traded goods
International Fisher Effect (IFE)
1. IFE suggests that the nominal interest rate contain
two components:
a. Expected inflation rate
b. Real interest rate
2. Implications of the IFE: currencies with high
interest rates will have high expected inflation and
will be expected depreciate
3. Implications of the IFE for foreign investors:
foreign investors will be adversely affected by the
effects of relatively high U.S. inflation rate if they
try to capitalize on high U.S. interest rates
Derivation of the International Fisher
Effect
1. Relationship between the interest rate (i)
differential between two countries and the
percentage change in the exchange rate (ef)

1  ih
ef  1
1 i f

2. Simplified relationship

e f  ih  i f
Exhibit 8.6 Summary of the International
Fisher Effect
Exhibit 8.7 Illustration of IFE Line (When Exchange
Rate Changes Perfectly Offset Interest Rates
Differentials)
Exhibit 8.9 Comparison of the IRP, PPP, and
IFE Theories

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