Inflation Vs Interest rates

7/29/2019 Inflation Vs Interest rates

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Relationship Between Inflation, Interest Rates, and

Exchange Rates

Purchasing Power Parity (PPP) is the notion that the ratiobetween domestic and foreign price levels should equal theequilibrium exchange rate between domestic and foreign

currencies.PPP theory takes two basic forms:

The absolute form, also called the law of one price,suggests that prices of similar products of two differentcountries should be equal when measured in a commoncurrency.

The relative form of PPP is an alternative version thataccounts for the possibility of market imperfections suchas transportation costs, tariffs, and quotas.


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Derivation of Purchasing Power Parity

(1 )

1(1 )

I

hef I

f


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A more simplified but less precise relationshipbased on PPP is

ef IhIfThat is, the exchange rate percentage change should be

approximately equal to the differential in inflation ratesbetween two countries.

Using PPP to ForecastSt+1 = S (1+ef)

St+1 = S[1+ (IhIf)]


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Assume that the exchange rate is in equilibrium initially.Then the home currency experiences a 5 % exchange rate,while the foreign country experiences a 3 % inflation rate.

According to PPP, the foreign currency will adjust as shown:

ef= 1+.05/1+ .031

= .0194, or 1.94%

Assume that the exchange rate is in equilibrium initially.Then

the home country experiences a 4% inflation rate, whilethe foreign country experiences a 7% inflation rate.

ef= 1+.04/1+ .071

= -.028, or2.8%.


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Graphic Analysis of Purchasing

Power Parity

-10

-5

0

5

10

-6 -4 -2 0 2 4 6

% change in foreign currency's spot rate

Ih-If(%)


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International Fisher Effect (IFE) Theory

IFE theory implies that exchange rates move to offset the

interest rate differentials.

Thefisher effectstates that the nominal interest rate (r) is

made up of two components:

(1) A real required rate of return, and

(2) Anticipated inflation

Assume that investors in the US expect a 6 percent rate ofinflation over one year, and require a real return of 2

percent over one year, the nominal interest rate on one-

year treasury would be 8 percent.


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International Fisher Effect

(1 ) 1

(1 )

ihe

f if


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Derivation of International Fisher Effect

The formula for the actual or so called effective (exchange rate adjusted) return

on a foreign bank deposit (or any market security) is

r = (1+if)(1+ef)1

According to the IFE, the effective return on a home investment should on average

be equal to the effective return on a foreign investment. That isr = ih

Accordingly, (1+if)(1+ef)1 = ih

Now solve for ef:

(1+if)(1+ef) = (1+ih)

(1 )(1 )

(1 )

(1 )1

(1 )

f

f

ihe

if

ihe

if


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Derivation of International Fisher Effect

A more simplified but less precise rule of the IFE is

ef ihif

That is, the exchange rate percentage change should beapproximately equal to the interest rate differential

between two countries.

Using IFE to Forecast

St+1 = S (1+ef)

St+1 = S[1+ (ihif)]


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Practical Problem on IFE

Assume that the interest rate on on a one-year insured home

bank deposit is 11 percent and the interest rate on a one-

year insured foreign bank deposit is 12 percent. For the

actual returns of these two investments to be similar fromthe perspective of investors in the home country, calculate

the percentage change in the value of the foreign currency

(ef) dominating the security.

(1 )1

(1 )

(1 .11)1

(1 .12)

.0089, .89%

h

f

f

ie

i

or


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Comparison of IRP, PPE, and IFE Theories

Theory Key Variables of Theory

Interest rate parity Forward rate Interest rate

Premium differential(or discount)

Purchasing power % change in Inflation rate

parity (PPP) spot exchange differential

rateInternational % change in Interest rate

Fisher Effect (IFE) spot exchange rate differential


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Practical Problems

1. Assume that the Canadian dollars spot rate is $.85 andthat the Canadian US inflation rates are similar. Thenassume that the Canadian experiences 4 % inflation,

while the US experiences 3 % inflation . According toPPP, what will be the new value of the C$ after it adjuststo the inflationary changes?

2. Australian dollars spot rate is $.90 and that Australianand US one year interest rates were initially 6 %. Then

assume that the Australian one-year interest rateincreases by 5 percentage points, while the US one-yearinterest rate remains unchanged. Using this informationand the IFE theory, forecast spot rate for one-year ahead.

Inflation Vs Interest rates

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