# Relationship among inflation interest rate and exchange

Objectives This chapter will: A. Explain the purchasing power parity ( PPP) theory and its implications for exchange rate changes B. Explain the. 8 - 3 Purchasing Power Parity (PPP) When a country's inflation rate rises relative to that of another country, decreased exports and increased imports depress. Chapter 8 Relationships Among Inlation, Interest Rates, and Exchange Rates Lecture Outline Purchasing Power Parity (PPP) Interpretations o PPP Rationale.

In addition, that country s demand or oreign goods should increase. Thus, the home currency o that country will weaken; this tendency should continue until the currency has weakened to the extent that a oreign country s goods are no more attractive than the home country s goods. Inlation dierentials are oset by exchange rate changes. Explain how you could determine whether PPP exists. Describe a limitation in testing whether PPP holds. One method is to choose two countries and compare the inlation dierential to the exchange rate change or several dierent periods.

Then, determine whether the exchange rate changes were similar to what would have been expected under PPP theory. A second method is to choose a variety o countries and compare the inlation dierential o each oreign country relative to the home country or a given period. Then, determine whether the exchange rate changes o each oreign currency were what would have been expected based on the inlation dierentials under PPP theory.

A limitation in testing PPP is that the results will vary with the base period chosen. The base period should relect an equilibrium position, but it is diicult to determine when such a period exists. Inlation dierentials between the U. Yet, in many years annual exchange rates between the corresponding currencies have changed by 10 percent or more. What does this inormation suggest about PPP? The inormation suggests that there are other actors besides inlation dierentials that inluence exchange rate movements.

Thus, the exchange rate movements will not necessarily conorm to inlation dierentials, and thereore PPP will not necessarily hold. Explain why PPP does not hold. PPP does not consistently hold because there are other actors besides inlation that inluences exchange rates. Thus, exchange rates will not move in perect tandem with inlation dierentials. In addition, there may not be substitutes or traded goods. Thereore, even when a country s inlation increases, the oreign demand or its products will not necessarily decrease in the manner suggested by PPP i substitutes are not available.

Explain the international Fisher eect IFE. What is the rationale or the existence o the IFE? What are the implications o the IFE or irms with excess cash that consistently invest in oreign Treasury bills?

Explain why the IFE may not hold. The IFE suggests that a currency s value will adjust in accordance with the dierential in interest rates between two countries. The rationale is that i a particular currency exhibits a high nominal interest rate, this may relect a high anticipated inlation.

Thus, the inlation will place downward pressure on the currency s value i it occurs. The implications are that a irm that consistently purchases oreign Treasury bills will on average earn a similar return as on domestic Treasury bills. The IFE may not hold because exchange rate movements react to other actors in addition to interest rate dierentials. Thereore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate dierentials, so that IFE may not hold.

What does this suggest about the uture strength or weakness o the dollar based on the IFE? Should oreign investors invest in U. The IFE would suggest that the U. Consequently, oreign investors who purchased U. Compare and contrast interest rate parity discussed in the previous chapterpurchasing power parity PPPand the international Fisher eect IFE. Interest rate parity can be evaluated using data at any one point in time to determine the relationship between the interest rate dierential o two countries and the orward premium or discount.

PPP suggests a relationship between the inlation dierential o two countries and the percentage change in the spot exchange rate over time. IFE suggests a relationship between the interest rate dierential o two countries and the percentage change in the spot exchange rate over time. IFE is based on nominal interest rate dierentials, which are inluenced by expected inlation. One assumption made in developing the IFE is that all investors in all countries have the same real interest rate.

What does this mean?

### RELATIONSHIPS AMONG INFLATION, INTEREST RATES, AND EXCHANGE RATES – University

The real return is the nominal return minus the inlation rate. I all investors require the same real return, then the dierentials in nominal interest rates should be solely due to dierentials in anticipated inlation among countries. I investors in the United States and Canada require the same real interest rate, and the nominal rate o interest is 2 percent higher in Canada, what does this imply about expectations o U. What do these inlationary expectations suggest about uture exchange rates?

Expected inlation in Canada is 2 percent above expected inlation in the U. I these inlationary expectations come true, PPP would suggest that the value o the Canadian dollar should depreciate by 2 percent against the U. PPP Applied to the Euro. Assume that several European countries that use the euro as their currency experience higher inlation than the United States, while two other European countries that use the euro as their currency experience lower inlation than the United States.

According to PPP, how will the euro s value against the dollar be aected? The high European inlation overall would reduce the U. According to the PPP theory, the euro s value would adjust in response to the weighted inlation rates o the European countries that are represented by the euro relative to the inlation in the U. I the European inlation rises, while the U. Source o Weak Currencies. Currencies o some Latin American countries, such as Brazil and Venezuela, requently weaken against most other currencies.

What concept in this chapter explains this occurrence? Why don t all U. Latin American countries typically have very high inlation, as much as percent or more. PPP theory would suggest that currencies o these countries will depreciate against the U. The high inlation discourages demand or Latin American imports and places downward pressure in their Latin American currencies.

Depreciation o the currencies osets the increased prices on Latin American goods rom the perspective o importers in other countries. The decision to hedge makes more sense i the expected degree o depreciation exceeds the degree o the orward discount. Also, keep in mind that some remittances cannot be perectly hedged anyway because the amount o uture remittances is uncertain.

Japan has typically had lower inlation than the United States.

## Chapter 8. Relationships Among Inflation, Interest Rates, and Exchange Rates. Lecture Outline

How would one expect this to aect the Japanese yen s value? Why does this expected relationship not always occur? Japan s low inlation should place upward pressure on the yen s value. Yet, other actors can sometimes oset this pressure. For example, Japan heavily invests in U. Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United States is 8 percent or one-year securities that are ree rom deault risk.

What does the IFE suggest about the dierential in expected inlation in these two countries? Using this inormation and the PPP theory, describe the expected nominal return to U. I investors rom the U. Thus, the inlation rate in Mexico is expected to be about 40 percent above the U. Using a 40 percent dierential, the Mexican peso should depreciate by about 40 percent.

Given a 48 percent nominal interest rate in Mexico and expected depreciation o the peso o 40 percent, U. This answer used the inexact ormula, since the concept is stressed here more than precision.

Shouldn t the IFE discourage investors rom attempting to capitalize on higher oreign interest rates? Why do some investors continue to invest overseas, even when they have no other transactions overseas? According to the IFE, higher oreign interest rates should not attract investors because these rates imply high expected inlation rates, which in turn imply potential depreciation o these currencies. Yet, some investors still invest in oreign countries where nominal interest rates are high.

This may suggest that some investors believe that 1 the anticipated inlation rate embedded in a high nominal interest rate is overestimated, or 2 the potentially high inlation will not cause substantial depreciation o the oreign currency which could occur i adequate substitute products were not available elsewhereor 3 there are other actors that can oset the possible impact o inlation on the oreign currency s value.

Assume that the inlation rate in Brazil is expected to increase substantially. How will this aect Brazil s nominal interest rates and the value o its currency called the real?

I the IFE holds, how will the nominal return to U. Brazil s nominal interest rate would likely increase to maintain the real return required by Brazilian investors. The Brazilian real would be expected to depreciate according to the IFE. I the IFE holds, the return to U. Even though 7 Chapter 8: Relationships Among Inlation, Interest Rates, and Exchange Rates they now earn a higher nominal interest rate, the expected decline in the Brazilian real osets the additional interest to be earned.

For the IFE to hold, the ollowing conditions are necessary: I conditions 1 or 2 do not hold, PPP may still hold, but investors may achieve consistently higher returns when investing in a oreign country s securities. Thus, IFE would be reuted. How will this spot rate adjust according to PPP i the United Kingdom experiences an inlation rate o 7 percent while the United States experiences an inlation rate o 2 percent?

According to PPP, the exchange rate o the pound will depreciate by 4. The one-year interest rate is 11 percent in the United States and 7 percent in Singapore. What will the spot rate be in one year according to the IFE? What is the orce that causes the spot rate to change according to the IFE? The anticipated inlation dierential can be derived rom interest rate dierential.

Deriving Forecasts o the Future Spot Rate. As o today, assume the ollowing inormation is available: Use the orward rate to orecast the percentage change in the Mexican peso over the next year. Use the dierential in expected inlation to orecast the percentage change in the Mexican peso over the next year.

Use the spot rate to orecast the percentage change in the Mexican peso over the next year. Inlation and Interest Rate Eects. The opening o Russia s market has resulted in a highly volatile Russian currency the ruble.

Russia s inlation has commonly exceeded 20 percent per month. Russian interest rates commonly exceed percent, but this is sometimes less than the annual inlation rate in Russia. Explain why the high Russian inlation has put severe pressure on the value o the Russian ruble. As Russian prices were increasing, the purchasing power o Russian consumers was declining.

This would encourage them to purchase goods in the U. Given the high Russian inlation, oreign demand or rubles to purchase Russian goods would be low.

Thus, the ruble s value should depreciate against the dollar, and against other currencies. Does the eect o Russian inlation on the decline in the ruble s value support the PPP theory?

How might the relationship be distorted by political conditions in Russia? The general relationship suggested by PPP is supported, but the ruble s value will not normally move exactly as speciied by PPP. The political conditions that could restrict trade or currency convertibility can prevent Russian consumers rom shiting to oreign goods.

Thus, the ruble may not decline by the ull degree to oset the inlation dierential between Russia and the U. Furthermore, the government may not allow the ruble to loat reely to its proper equilibrium level. Does it appear that the prices o Russian goods will be equal to the prices o U. Russian prices might be higher than U. The exchange rate cannot ully adjust i there are barriers on trade or currency convertibility. Will the eects o the high Russian inlation and the decline in the ruble oset each other or U.

That is, how will U. This may cause a reduction in the U. Beore the Asian crisis, many investors attempted to capitalize on the high interest rates prevailing in the Southeast Asian countries although the level o interest rates primarily relected expectations o inlation. Explain why investors behaved in this manner.

Why does the IFE suggest that the Southeast Asian countries would not have attracted oreign investment beore the Asian crisis despite the high interest rates prevailing in those countries? The investors behavior suggests that they did not expect the international Fisher eect IFE to hold. Since central banks o some Asian countries were maintaining their currencies within narrow bands, they were eectively preventing the exchange rate rom depreciating in a manner that would oset the interest rate dierential.

Consequently, superior proits rom investing in the oreign countries were possible. I investors believed in the IFE, the Asian countries would not attract a high level o oreign investment because o exchange rate expectations. Speciically, the high nominal interest rate should relect a high level o expected inlation. According to purchasing power parity PPPthe higher interest rate should result in a weaker currency because o the implied market expectations o high inlation.

IFE Applied to the Euro. Given the recent conversion o several European currencies to the euro, explain what would cause the euro s value to change against the dollar according to the IFE. I interest rates change in these European countries whose home currency is the euro, the expected inlation rate in those countries change, so that the inlation dierential between those countries and the U. Thus, there may be an impact on the value o the euro, because a change in the inlation dierential aects trade lows and thereore aects the exchange rate.

Current one-year interest rates in Europe are 5 percent, while one-year interest rates in the U. One year later, she converts the euros back to dollars.

According to the IFE, what should the spot rate o the euro in one year be? What must the spot rate o the euro be in one year or Beth s strategy to be successul? Convert dollars to euros: Assume the ollowing inormation is available or the U. According to PPP, what is the expected spot rate o the euro in one year? According to the IFE, what is the expected spot rate o the euro in one year?

Reconcile your answers to parts a and c. The one-year risk-ree rate in the U. Assume that interest rate parity exists. What is the orward rate premium? What is the one-year orward rate o the peso? Based on the international Fisher eect, what is the expected change in the spot rate over the next year? I the spot rate changes as expected according to the IFE, what will be the spot rate in one year? Compare your answers to b and d and explain the relationship.

According to the IFE, the expected change in the peso is: The answers are the same. When IRP holds, the orward rate premium and the expected percentage change in the spot rate are derived in the same manner.

Thus, the orward premium serves as the orecasted percentage change in the spot rate according to IFE.

• 08. RELATIONSHIPS AMONG INFLATION, INTEREST RATES, AND EXCHANGE RATES
• Relationships among Inflation, Interest Rates, and Exchange Rates

How could you use regression analysis to determine whether the relationship speciied by PPP exists on average? Speciy the model, and describe how you would assess the regression results to determine i there is a signiicant dierence rom the relationship suggested by PPP.

A regression model could be applied to historical data to test PPP. The model is speciied as: I PPP holds, a 0 should equal zero, and a 1 should equal 1. A t-test on a 0 and a 1 is as ollows: Describe a statistical test or the IFE. A regression model could be applied to historical data to test IFE. I IFE holds, a 0 should equal zero and a 1 should equal 1. A t-test on a 0 and a 1 is shown below: Would PPP be more likely to hold between the United States and Hungary i trade barriers were completely removed and i Hungary s currency were allowed to loat without any government intervention?

Would the IFE be more likely to hold between the United States and Hungary i trade barriers were completely removed and i Hungary s currency were allowed to loat without any government intervention? Changes in international trade result rom inlation dierences and aects the exchange rate by aecting the demand or the currency and the supply o the currency or sale. The Hamburger Standard 11 Exhibit 6.

The Hamburger Standard cont. Interpretations of Purchasing Power Parity b. Relative Form of PPP If the assumptions of absolute PPP theory are relaxed, we observe relative purchasing power parity This idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between countries over a period of time determines the change in exchange rates Moreover, if the spot rate between 2 countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot rate 13 Relative Purchasing Power Parity 1.

Changes in exchange rate. What is the new exchange rate? PPP holds and exchange rates are at equilibrium. Two general conclusions can be drawn from the tests: PPP holds up well over the very long term but is poor for short term estimates The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets 20 A.

### Chapter 8. Relationships Among Inflation, Interest Rates, and Exchange Rates. Lecture Outline - PDF

Confounding Effects — other factors are determinants to exchange rate. No Substitutes for traded goods 23 Interest Rates and Exchange Rates Prices between countries are related by exchange rates and now we discuss how exchange rates are linked to interest rates The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.

Home nominal interest rate. Foreign nominal interest rate.