Basic 8 Purchasing Power Parity

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Relationships Between Inflation,Interest Rates, and Exchange Rates

Relationships Between Inflation,Interest Rates, and Exchange Rates

88ChapterChapter

South-Western/Thomson Learning 2003


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Chapter Objectives

To explain the theories ofpurchasing power parity (PPP) and

international Fisher effect (IFE), and theirimplications for exchange rate changes;

and

To compare the PPP theory, IFE theory,and theory of interest rate parity (IRP).


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Purchasing Power Parity (PPP)

When one countrys inflation rate risesrelative to that of another country,

decreased exports and increased importsdepress the countrys currency.

The theory ofpurchasing power parity

(PPP) attempts to quantify this inflation -exchange rate relationship.


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Interpretations of PPP

The absolute form of PPP, or the law ofone price, suggests that similar products

in different countries should be equallypriced when measured in the same

currency.

The relative form of PPPaccounts formarket imperfections like transportationcosts, tariffs, and quotas. It states that the

rate of price changes should be similar.


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Rationale behind PPP Theory

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

o U.S. imports from U.K. and q 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 u priceU.S. goods, &

in the U.K., priceU.S. goods e priceU.K. goods.


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Derivation of PPP

Assume home countrys price index (Ph) =foreign countrys price index (Pf)

When inflation occurs, the exchange ratewill 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 countryef = % change in the value of the foreign

currency


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Since Ph = Pf, solving forefgives:

ef =(1 + Ih )

1(1 + If) IfIh > If, ef> 0 (foreign currency appreciates)

IfIh < If, ef< 0 (foreign currency depreciates)

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

From the home country perspective, both

price indexes rise by 5%.

Derivation of PPP


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Simplified PPP Relationship

When the inflation differential is small, thePPP relationship can be simplified as

ef } Ih _ If

Suppose IU.S. = 9%, IU.K. = 5%. Then PPPsuggests 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.


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Testing the PPP Theory

Conceptual Test

Plot the actual inflation differential andexchange rate % change for two or more

countries on a graph.

If the points deviate significantly from the

PPP line over time, then PPP does nothold.


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Statistical Test

Apply regression analysis to the historicalexchange rates and inflation differentials:

ef = a0 + a1 { (1+Ih)/(1+If) - 1 } + Q

The appropriate t-tests are then applied to

a0 and a1, whose hypothesized values are0 and 1 respectively.



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Empirical studies indicate that therelationship between inflation differentials

and exchange rates is not perfect even inthe long run.

However, the use of inflation differentials

to forecast long-run movements inexchange rates is supported.



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Why PPP Does Not Occur

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.


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PPP in the Long Run

PPP can be tested by assessing a realexchange rate over time.

The real exchange rate is the actualexchange rate adjusted for inflationary

effects in the two countries of concern.

If this rate reverts to some mean level overtime, this would suggest that it is constantin the long run.


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International Fisher Effect (IFE)

According to the Fisher effect, nominalrisk-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.


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International Fisher Effect (IFE)

The internationalFisher effect (IFE) theorysuggests that currencies with higher

interest rates will depreciate because thehigher rates reflect higher expected

inflation.

Hence, investors hoping to capitalize on ahigher foreign interest rate should earn areturn no better than what they would

have earned domestically.


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According to the IFE, E(rf), the expectedeffective return on a foreign money market

investment, should equal rh , the effectivereturn on a domestic investment.

rf = (1 + if) (1 + ef) 1

if = interest rate in the foreign countryef = % change in the foreign currencys

value

rh = ih = interest rate in the home country

Derivation of the IFE


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Setting rf = rh : (1 + if)(1 + ef) 1 = ih

Solving foref: ef = (1 + ih ) _ 1(1 + if)

Ifih > if, ef> 0 (foreign currency appreciates)

Ifih < if, ef< 0 (foreign currency depreciates)

Ifih = 8% & if= 9%, ef= 1.08/1.09 1 = -.92%

This will make the return on the foreign

investment equal to the domestic return.



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When the interest rate differential is small,the IFE relationship can be simplified as

ef } ih _ if

If the British rate on 6-month depositswere 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.



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Graphic

Analysis of the IFE

The point of the IFE theory is that if a firmperiodically tries to capitalize on higher

foreign interest rates, it will achieve a yieldthat 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.


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Tests of the IFE

If the actual points of interest rates andexchange rate changes are plotted over

time on a graph, we can see whether thepoints 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.


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A statistical test can be developed byapplying regression analysis to the

historical exchange rates and nominalinterest rate differentials:

ef = a0 + a1 { (1+ih)/(1+if) 1 } + Q

The appropriate t-tests are then applied toa0 and a1, whose hypothesized values are0 and 1 respectively.

Tests of the IFE


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Why the IFE Does Not Occur

Since the IFE is based on PPP, it will nothold when PPP does not hold.

For example, if there are factors other thaninflation that affect exchange rates, the

rates will not adjust in accordance with

the inflation differential.


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Application of the IFE to the Asian Crisis

According to the IFE, the high interestrates in Southeast Asian countries before

the Asian crisis should not attract foreigninvestment because of exchange rate

expectations.

However, since some central banks were

maintaining their currencies within narrow

bands, some foreign investors were

motivated.


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Unfortunately for these investors, theefforts made by the central banks to

stabilize the currencies were overwhelmedby market forces.

In essence, the depreciation in theSoutheast Asian currencies wiped out the

high level of interest earned.


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Impact of Inflation on an MNCs Value

? A

v!

n

tt

jtjtj

k1=

1,,

1

ERECFE

=V l

E (CFj,t) = expected cash flows in currencyjto be received

by the U.S. parent at the end of period t

E (ERj,t) = expected exchange rate at which currencyjcan

be converted to dollars at the end of period t

k = weighted average cost of capital of the parent

Effect of Inflation


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Purchasing Power Parity (PPP) Interpretations of PPP

Rationale behind PPP Theory Derivation of PPP

Using PPP to Estimate Exchange Rate

Effects

Simplified PPP Relationship

Chapter Review


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Chapter Review

Purchasing Power Parity (PPP) continued Testing the PPP Theory

Why PPP Does Not Occur PPP in the Long Run


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Chapter Review

International Fisher Effect (IFE) Derivation of the IFE

Tests of the IFE Why the IFE does Not Occur


Impact of Foreign Inflation on the Value ofthe MNC

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Basic 8 Purchasing Power Parity