Chapter 8 - Relationship Among Inflation, Interest Rates, and Exchange Rates

Two forms of PPP theory

-Absolute *The price of the same basket of products in two different countries should be equal when measured in a common currency -Relative *The rate of change in the price of the same basket of goods in two different countries should be comparable when measured in a common currency

In PPP, a relatively low local inflation leads to

-Imports decreasing -Exports increasing -Local currency appreciating

In PPP, a relatively high local inflation leads to

-Imports increasing -Exports decreasing -Local currency depreciating

In PPP, when local and foreign inflation are similar,

-No impact on import/export volume -Local currency unaffected

The actual ("effective") (i.e. exchange rate-adjusted) return on a foreign bank deposit

1(1 + if)(1 + ef) - 1

IFE suggests

1. How each country's nominal interest rate can be used to derive its expected inflation rates 2. How the difference in inflation rates between two countries signals an expected change in the exchange rate

Under IFE, a relatively low local interest rate (brought about from relatively low expected local inflation) will lead to

1. Imports decreasing 2. Exports increasing 3. Local currency appreciating by level of inflation differential

Under IFE, a relatively high local interest rate (brought about from relatively high expected local inflation) will lead to

1. Imports increasing 2. Exports decreasing 3. Local currency depreciating by level of inflation differential

If the Australian interest rates increase from 6 to 11 percent what, according to the IFE, is the underlying factor causing such a change? Furthermore, if U.S. investors believe in IFE, will they attempt to capitalize on these high interest rates?

According to IFE, the increase in interest rates by 5 percentage points reflects an increase in expected inflation by 5 percentage points. If the inflation adjustment occurs, then the balance of trade should be affected because Australian demand for U.S. goods rises while the U.S. demand for Australian goods declines. Thus the Australian dollar should weaken. If U.S. investors believed in IFE, they would not attempt to capitalize on higher Australian interest rates because they would expect the Australian dollar to depreciate over time.

Use PPP to explain how the values of currencies of Eastern European countries might change if those countries experience high inflation, while the U.S. experiences low inflation.

High inflation will cause a balance-of-trade adjustment, whereby the United States will reduce its purchases of goods in these countries, while the demand for U.S. goods by these countries should increase (according to PPP). Consequently, there will be downward pressure on the values of the Eastern European currencies.

A U.S. importer of Japanese computer components pays for the components in yen. The importer is not concerned about a possible increase in Japanese prices (charged in yen) because of the likely offsetting effect caused by PPP. Explain what this means.

If Japanese prices rise because of inflation in that country, then the value of the yen should decline. Thus even though the importer might need to pay more yen, he would benefit from a weaker yen value (he would pay fewer dollars for a given amount in yen). Thus there could be an offsetting effect if PPP holds.

Summary of IRP

Key variables -Forward rate premium (or discount) -Nominal interest rate differential Summary The forward rate of one currency with respect to another will contain a premium (or discount) 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.

Summary of PPP

Key variables -Percentage change in spot exchange rate -Inflation rate differential Summary The spot rate of one currency with respect to another will change in reaction to the differential in inflation rates between the countries. Consequently, the purchasing power for consumers when purchasing products in their own country will be similar to their purchasing power when importing products from the foreign country.

Summary of IFE

Key variables -Percentage change in spot exchange rate -Nominal interest rate differential Summary The spot rate of one currency with respect to another will change in accordance with the differential in nominal interest rates between the two countries (and thus with the expected inflation rate differential). Consequently, the return to investors from investing in foreign money market securities will, on average, be no higher than the return on domestic money market securities.

Use what you know about tests of PPP to explain why the U.S. importer of Japanese computer components should be concerned about his future payments.

PPP does not necessarily hold. In our example, Japanese inflation could rise (causing the importer to pay more yen), and yet the Japanese yen would not necessarily depreciate by an offsetting amount, or at all. Therefore, the dollar amount to be paid for Japanese supplies could increase over time.

PPP/IFE formulas

Ph(1 + Ih) = price index home Pf(1 + If) = price index foreign Foreign price index (home perspective) = Pf(1 + If) * (1 + ef) ef = % change in value of foreign currency ef = (1 + Ih / 1 + If) - 1 ef ~= Ih - If *For when Ih - If is small or If ~= 0 *Change I inflation for i interest rate to adapt formulas to IFE

Purchasing Power Parity (PPP) theory specifies

a precise relationship between the relative inflation rate of two countries and their exchange rates. *Exchange rate always follows changes in inflation to offset change in inflation

The international Fisher effect (IFE) specifies

a precise relationship between the relative nominal interest rates of two countries and their exchange rates *Formally: E[S(T)] = S(0) * (1+i(H)) / (1+i(F))^T

IFE suggests that an investor who periodically invests in interest-bearing foreign securities will, on average,

achieve a return similar to what is possible domestically *This implies that the currency of the country with high nominal interest rates will depreciate to offset the interest rate advantage achieved by foreign investments

PPP cannot be used to anticipate how exchange rates might change because

actual inflation rates are not known until a period is over

As inflation rises, demand for a country's currency

declines (because its exports decline given their higher prices) while its inhabitants increase their imports

All points along the IFE line reflect

exchange rate movements to offset the differential in interest rates (i.e. when accounting for exchange rate movements, investors will end up achieving the same return (yield) whether they invest at home or in a foreign country)

Points below the IFE line generally reflect

higher returns from investing in foreign deposits

The PPP line connects all points which show that

if there is an inflation differential of X percent between the home and foreign currency, the foreign currency should adjust by X percent in response to the inflation differential

Absolute PPP is based on the idea that

in the absence of international barriers, consumers will shift their demand to wherever prices are lowest *Transportation costs, tariffs, and quotas render this form of PPP unrealistic

PPP is most present in cases where

interest rates are extremely high (as this usually happens in less developed countries with high inflation and currencies which tend to weaken over time)

There is evidence that IFE does not hold during all periods meaning that

investment in foreign short-term securities may achieve a higher return than what is possible domestically *A firm that attempts to achieve this higher return also incurs the risk that the currency denominating the foreign security depreciates against the investor's home currency during that investment period by more than the nominal interest rate differential **In this case, the foreign security would generate a lower return than a domestic security, even though it has a higher nominal interest rate

PPP theory has been disproven in reality, but it still offers a

logical explanation for why currencies of countries with high inflation tend to weaken over time (i.e. exchange rate change is usually higher than inflation differential)

Points above the IFE line generally reflect

lower returns (compared to domestic) from investing in foreign deposits

All points to the left (or above) the PPP line represent

more favorable purchasing power for foreign products

All points to the right (or below) the PPP line represent

more favorable purchasing power for home country products

Real =

nominal - expected inflation *Can be used to derive expected inflation and thus address weakness of PPP

Fisher Effect (not international)

nominal interest = real interest + inflation

The foundation of the Fisher effect is

potential savers in a country should require that their return from a local savings deposit exceeds the expected rate of inflation in that country *As the nominal interest rates represent returns to local savers and should exceed expected inflation, the real (inflation-adjusted) interest rate should be positive

Past theories have shown, contrary to PPP and IFE,

that a country with higher interest can attract more capital flows (and therefore cause the currency to strengthen), in addition to how a central bank may purposely try to raise interest rates to attract funds to strengthen the local currency

IRP, PPP, and IFE all relate to

the determination of exchange rates but have different implications

If the real interest rate required is the same across countries, the expected inflation differential can be reduced to

the difference between each country's nominal interest rate

PPP theory suggests that

the equilibrium exchange rate between two countries will adjust by about the same magnitude as the difference between the two countries' inflation rates

The derivation of expected inflation from nominal interest will not always be accurate if

the nominal interest does not properly reflect its level of inflation over a period *Another weakness of IFE is that it relies on PPP, which ignores other factors which may affect exchange rate changes

Under IFE, when local and foreign interest rates are similar (brought on by local and foreign expected inflation rates being similar)

there is no impact on import or export volume and subsequently no impact on the the value of the local currency

The relative form of PPP accounts for such things as

transportation costs, tariffs, and quotas, thereby making it more realistic than the absolute PPP