RelationshipsamongInflation,InterestRates,andExchangeRates.pdf

Chapter8 Relationships among Inflation, Interest Rates, and Exchange Rates J. Gaspar: Adapted from Jeff Madura, International Financial Management 8. 1 International Finance Theories (cont) ? Purchasing Power Parity (PPP): At equilibrium, the future spot rate of a foreign currency will differ (in %) from the current spot rate by an amount that equals (in %) the inflation differential between the home and foreign countries. ? International Fisher Effect (IFE): At equilibrium, the future spot rate of a foreign currency will differ (in %) from the current spot rate by an amount that equals (in %) the nominal interest rate differential between the home and foreign countries 8. 2 Chapter Objectives ? To explain the purchasing power parity (PPP) and international Fisher effect (IFE) theories, and their implications for exchange rate changes; and ? To compare the PPP, IFE, and interest rate parity (IRP) theories. 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 the high-inflation country’s currency. ? Purchasing power parity (PPP) theory attempts to quantify this inflation – exchange rate relationship. 8. 4 Interpretations of PPP ? The absolute form of PPP is an extension of the law of one price. It suggests that the prices of the same products in different countries should be equal when measured in a common currency. ? The relative form of PPP accounts for market distortions like transportation costs, tariffs, taxes, and quotas. It states that the rate of price changes should be similar. 8. 5