(2) Purchasing Power Parity
International Fisher Effect (IFE)
it uses the difference in interest rates (rather than inflation) to explain why exchange rates shift over time. - High interest rate can attract a strong demand for a local currency and so may put upward pressure on that currency's value. - interest rates and inflation are often directly related.
Interest Rate Parity (IRP)
-Forward rate premium -Interest rate differential - The forward rate of one currency with respect to another will contain a premium that is 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.
Comparing all tree -IRP -PPP -IFE
Even though all three of these theories relate to the determination of exchange rates, they have different implications. The IRP theory focuses on why the forward rate differs from the spot rate and on how much the difference should be at a specific point in time. In contrast, the PPP theory and IFE theory both focus on how a currency's spot rate will change over time. Whereas PPP theory suggests that the spot rate will change in accordance with inflation differentials, IFE theory suggests that it will change in accordance with interest rate differentials. Nonetheless, PPP is related to IFE because expected inflation differentials influence the nominal interest rate differentials between two countries. -Some generalizations about countries can be made by applying these theories. High- inflation countries tend to have high nominal interest rates (due to the Fisher effect). Their currencies tend to weaken over time (because of the PPP and IFE), and the for- ward rates of their currencies normally exhibit large discounts (due to IRP).
Purchasing Power Parity (PPP)
attempts to quantify the relationship between inflation and the exchange rate. 1)THE ABSOLUTE FORM of PPP is based on the idea that, in the absence of international barriers, consumers will shift their demand to wherever prices are lowest. If there is a discrepancy in the prices as measured by such a common currency, then demand should shift so that these prices converge. 2) RELATIVE FORM of PPP accounts for such market imperfections as transportation costs, tariffs, and quotas. This version acknowledges that these imperfections make it unlikely for prices of the same basket of goods in different countries to be the same when measured in a common currency.