Relationships among Inflation,Interest Rates, and Exchange ....pptVIP

;Chapter Objectives;Purchasing Power Parity (PPP);Interpretations of PPP;Rationale behind PPP Theory;Derivation of PPP;Derivation of PPP;Simplified PPP Relationship;Graphic Analysis of Purchasing Power Parity;Testing the PPP Theory;Empirical studies indicate that the relationship between inflation differentials and exchange rates is not perfect even in the long run. However, the use of inflation differentials to forecast long-run movements in exchange rates is supported. A limitation in the tests is that the choice of the base period will affect the result.;Why PPP Does Not Occur;PPP in the Long Run;International Fisher Effect (IFE);International Fisher Effect (IFE);International Fisher Effect (IFE);According to the IFE, E(rf ), the expected effective return on a foreign money market investment, should equal rh , the effective return on a domestic investment. rf = (1 + if ) (1 + ef ) – 1 if = interest rate in the foreign country ef = % change in the foreign currency’s value rh = ih = interest rate in the home country;Setting rf = rh : (1 + if ) (1 + ef ) – 1 = ih Solving for ef : ef = (1 + ih ) _ 1 (1 + if );When the interest rate differential is small, the IFE relationship can be simplified as ef ? ih _ if;Graphic Analysis of the International Fisher Effect;Graphic Analysis of the IFE;Tests of the IFE;Tests of the International Fisher Effect;Why the IFE Does Not Occur;Comparison of the IRP, PPP, and IFE Theories;Comparison of the IRP, PPP, and IFE Theories