Chapter 8

Relationships among Inflation, Interest Rates, and Exchange Rates

Purchasing Power Parity (PPP)

 PPP attempts to quantify the inflation-exchange rate relationship

 Absolute Form PPP – Without international barriers consumers shift their demand to wherever
prices are lower. The prices of the basket of products in two different should be equal when
measured in a common currency.

 Relative Form of PPP – Because of market frictions (tariffs, transportation costs and quotas)
prices of the same basket of products in different countries will not necessarily be the same
when measured in a common currency.

With inflation home country price index become P home (1+Ihome)

Price index of foreign country will change with inflation P foreign (1+Iforeign)

h = home country f = foreign country I = inflation rate

With inflation the foreign country price index from the perspective of the home country becomes

Pforeign (1+Iforeign)(1 + eforeign)

e =% change in foreign currency to home

According to Purchasing Power Parity (PPP) the new price index of home country with inflation should
equal the new price index of foreign country

Phome (1+Ihome) = Pforeign (1+Iforeign)(1 + eforeign)

Solving for e (assume Phome = Pforeign initially)

% change in value of the foreign currency exchange rate will depend on the rates of expected inflation in
the two countries

e =% change in foreign exchange rate = (1 + I h) / (1 + If) - 1

h = home country f = foreign country I = inflation rate

 Assume the exchange of two countries is in equilibrium. Then the home country experiences
5% inflation and the foreign country experiences a 3% rate.

% change in foreign currency to home =

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21. Assume that the inflation rate in Singapore is 3%, while the inflation rate in the U.S. is 8%.
According to PPP, the Singapore dollar should ____ by ____%.

According to PPP Adjusted Spot Rate = Spot(1 + Ih) / (1 + If)

PPP Does Not Occur – because of confounding effects and lack of substitutes for some traded goods

Remember exchange rates are driven by more than inflation

e = f (∆INF, ∆INT, ∆INC, ∆GC, ∆EXP)

e = percentage change in the spot rate.

∆INF = Change in differential of inflation between countries

∆INT = Change in differential in interest between countries

∆INC = Change in income levels of US and foreign country

∆GC = Change in government controls

∆EXP = Change in expectations of future exchange rate

For PPP to work if the price of an import becomes too high the consumer will switch to a substitute.
May not happen.

International Fisher Effect (IFE)

 Use interest rates rather than inflation rates to explain why exchange rates fluctuate over time.

Fisher Effect Risk Free interest rate nominal = (1 + real rate) (1 + expected inflation rate) - 1

Interest rates in two countries differ because of differences in inflation rates which are buried in the
interest rates. The change in exchange rates should reflect the change in inflation and the exchange
rate adjust based on that. (Like PPP). Also investing in another country with higher interest rates will
not give any higher return than the investor’s home country after adjusting for inflation.

If the market’s guess about inflation is buried in the interest rate of a country and each country has the
same real rate of interest then investing in another country with a higher interest rate may not be
beneficial. When the investor repurchases his home currency the exchange rates should have adjusted
so you only make the return of home country.

One year risk free yield in USA = 4% One year risk free yield in Japan =2%

Spot Yen $.021/Yen

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 If the yields reflect the actual inflation over the year what is the exchange rate in one year. Same
formula as forward markets with interest rate parity (IRP).

International Fisher Effect

Future Spot Rate = Spot Rate [(1+Interest Ratehome)/(1+Interest RateForeign)]

Change in Spot Rate e = [(1+Interest Ratehome)/(1+Interest RateForeign)] - 1

24. IFE. Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-year
interest rates in Europe are 5 percent, while one-year interest rates in the U.S. are 3 percent. Beth
converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back
to dollars. The current spot rate of the euro is $1.10.

a. According to the IFE, what should the spot rate of the euro in one year be?

b. If the spot rate of the euro in one year is $1.00, what is Beth’s percentage return from her
strategy?

c. If the spot rate of the euro in one year is $1.08, what is Beth’s percentage return from her
strategy?

d. What must the spot rate of the euro be in one year for Beth’s strategy to be successful?

25. Integrating IRP and IFE. Assume the following information is available for the U.S. and Europe:

U.S. Europe

Nominal interest rate 4% 6%

Expected inflation 2% 5%

Spot rate ----- $1.13

One-year forward rate ----- $1.10

a. Does IRP hold?

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 b. According to PPP, what is the expected spot rate of the euro in one year?

c. According to the IFE, what is the expected spot rate of the euro in one year?
.

26. IRP. The I-year risk-free interest rate in Mexico is 10 percent. The 1-year risk-free rate
in the United States is 2 percent. Assume that interest rate parity exists. The spot rate of the
Mexican peso is $.14.

a. What is the forward rate premium?

b. What is the 1-year forward rate of the peso?

c. Based on the international Fisher effect, what is the expected change in the spot rate
over the next year?

d. If the spot rate changes as expected according to the IFE, what will be the spot rate
in 1 year?

e. Compare your answers to (b) and (d) and explain the relationship

20. Deriving Forecasts of the Future Spot Rate. As of today, assume the following information is
available:

U.S. Mexico

Real rate of interest required

by investors 2% 2%
Nominal interest rate 11% 15%
Spot rate — $.20
One-year forward rate — $.19

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 a. Use the forward rate to forecast the percentage change in the Mexican peso over the next year.

b. Use the differential in expected inflation to forecast the percentage change in the Mexican peso
over the next year.

c. Use the spot rate to forecast the percentage change in the Mexican peso over the next year.

35. Implications of PPP. Today’s spot rate of the Mexican peso is $.10. Assume that purchasing
power parity holds. The U.S. inflation rate over this year is expected to be 7%, while the Mexican
inflation over this year is expected to be 3%. Wake Forest Co. plans to import from Mexico and will
need 20 million Mexican pesos in one year. Determine the expected amount of dollars to be paid by
the Wake Forest Co. for the pesos in one year.

39. PPP and Real Interest Rates. The nominal (quoted) U.S. one-year interest rate is 6%, while the
nominal one-year interest rate in Canada is 5%. Assume you believe in purchasing power parity. You
believe the real one-year interest rate is 2% in the U.S, and that the real one-year interest rate is 3% in
Canada. Today the Canadian dollar spot rate at $.90. What do you think the spot rate of the Canadian
dollar will be in one year?