8
Chapter
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.
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.
The relative form of PPP accounts for market
imperfections like transportation costs, tariffs,
and quotas. It states that the rate of price changes
should be similar.
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.
Assumehome country’s price index (Ph) =
foreign country’s price index (Pf)
When inflation occurs, the exchange rate will
adjust to maintain PPP:
Pf (1 + If ) (1 + ef ) = Ph (1 + Ih )
where Ih = inflation rate in the home country
If = inflation rate in the foreign country
ef = % change in the value of the foreign
currency
Since Ph = Pf , solving for ef gives:
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%
From the home country perspective, both price
indexes rise by 5%.
When the inflation differential is small, the PPP
relationship can be simplified as
e f » Ih _ If
Suppose IU.S. = 9%, IU.K. = 5%. Then PPP suggests
that e£ 4%.
Then, U.K. goods will cost 5+4=9% more to U.S.
consumers, while U.S. goods will cost 9-4=5%
more to U.K. consumers.
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.
Statistical Test
Apply regression analysis to the historical
exchange rates and inflation differentials:
ef = a0 + a1 { (1+Ih)/(1+If) - 1 } + m
The appropriate t-tests are then applied to a 0 and
a1, whose hypothesized values are 0 and 1
respectively.
Empirical studies indicate that the relationship
between inflation differentials and exchange rates
is not perfect even in the long run.
However, the use of inflation differentials to
forecast long-run movements in exchange rates is
supported.
PPP may not occur consistently due to:
confounding effects, and
Exchange rates are also affected by differentials in
interest rates, income levels, and risk, as well as
government controls.
lack of substitutes for traded goods.
PPP can be tested by assessing a “real” exchange
rate over time.
The real exchange rate is the actual exchange rate
adjusted for inflationary effects in the two countries of
concern.
If this rate reverts to some mean level over time,
this would suggest that it is constant in the long
run.
According to the Fisher effect, nominal risk-free
interest rates contain a real rate of return and an
anticipated inflation.
If the same real return is required, differentials in
interest rates may be due to differentials in
expected inflation.
According to PPP, exchange rate movements are
caused by inflation rate differentials.
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.
According to the IFE, E(rf ), the expected
effective return on a foreign money market
investment, should equal rh , the effective return
on a domestic investment.
rf = (1 + if ) (1 + ef ) – 1
if = interest rate in the foreign country
ef = % change in the foreign currency’s
value
rh =ih = interest rate in the home country
Setting rf = rh : (1 + if ) (1 + ef ) – 1 = ih
Solving for ef : e =
(1 + i h ) _ 1
f
(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.
When the interest rate differential is small, the
IFE relationship can be simplified as
e f » 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.
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.
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.
A statistical test can be developed by applying
regression analysis to the historical exchange
rates and nominal interest rate differentials:
ef = a0 + a1 { (1+ih)/(1+if) – 1 } + m
The appropriate t-tests are then applied to a0 and
a1, whose hypothesized values are 0 and 1
respectively.
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.
According to the IFE, the high interest rates in
Southeast Asian countries before the Asian crisis
should not attract foreign investment because of
exchange rate expectations.
However, since some central banks were
maintaining their currencies within narrow bands,
some foreign investors were motivated.
Unfortunately for these investors, the efforts
made by the central banks to stabilize the
currencies were overwhelmed by market forces.
In essence, the depreciation in the Southeast
Asian currencies wiped out the high level of
interest earned.
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