RelationshipBetweenInflation InterestRatesandExchangeRates LearningOutcomes LearningOutcomes LearningoutcomesforLecture7 A Discussthepurchasingpowerparity PPP theoryanditsimplicationsforexchangeratechangesB DiscusstheInternationalFishereffect IFE theoryanditsimplicationsforexchangeratechangesC ComparethePPPtheory theIFEtheory andthetheoryofinterestrateparity IRP whichwasintroducedinthepreviouschapter PPP PurchasingPowerParity PPP 1 InterpretationsofPurchasingPowerParitya AbsoluteFormofPPP Itsuggeststhatpricesofthesamebasketofproductsin2differentcountriesshouldbeequalwhenmeasureinacommoncurrency Realistically theexistenceoftransportationcosts tariffsandquotaspreventabsolutePPPb RelativeFormofPPP Statethattherateofchangeinthepricesofthebasketsshouldbesomewhatsimilarwhenmeasuredinacommoncurrency aslongastransportationcostsandtradebarriersareunchanged RelativePPP 2 RationalebehindPurchasingPowerParityTheory ExchangerateadjustmentisnecessaryfortherelativepurchasingpowertobethesamewhetherbuyingproductslocallyorfromanothercountryAppreciation Depreciationoffutureexchangerate InflationdifferentialRefertoe g inp 234 RelativePPP DerivationofPPP ef 1 Ih 1 If 1ef changeinforeigncurrencyIh InflationofhomecountryIf InflationofforeigncountryTheformulareflectstherelationshipbetweenrelativeinflationratesandexchangeratesaccordingtoPPPIfIh If efispositive foreigncurrencywillappreciateIfIh If efisnegative foreigncurrencywilldepreciate Derivation Commodities DerivationofPPP 4 UsingPPPtoEstimateExchangeRateEffects Refertop 235 236fore g a UsingaSimplifiedPPPRelationship whereby ef Ih Ifb Exhibit8 1p 237summarizesPPP GraphicAnalysisofPPP 5 GraphicAnalysis a PPPLineb PurchasingPowerDisparity Graphic PPPLine TriangularArbitrage PurchasingPowerDisparity Movement ConfoundingEffects ConfoundingEffects InternationalFisherEffect IFE UsesinterestratesratherthaninflationdifferentialstoexplainexchangerateButitiscloselyrelatedtoPPPbecauseinterestratesareoftenhighlycorrelatedwithinflationratesFisher seffectstate Realinterestrate NominalinterestrateminusexpectedinflationrateIFEsuggeststhatcurrencieswithhighinterestrateswillhavehighinflationratesandthereforewillbeexpectedtodepreciateRefertop 244fore g andExhibit8 5 IFE DerivationofIFE ProductLifeCycle ef 1 iH 1 iF 1efis inthevalueofforeigncurrencydenominatingthesecurityiHishomeinterestrateiFisforeigninterestrateiH iF efwillbepositivebecausetherelativelylowforeigninterestratereflectslowinflationaryexpectationsintheforeigncountry foreigncurrencywillappreciate forwardpremium iH iF efwillbenegativebecausetherelativelyhighforeigninterestratereflectshighinflationaryexpectationsintheforeigncountry foreigncurrencywilldepreciate forwarddiscount IFE IFE RefertoExhibit8 6p 247forsummaryofIFERefertop 246 247fore g Simplifiedrelationship ef iH iF thatisthepercentagechangeinexchangerateovertheinvestmenthorizonwillequalinterestratesdifferentialsbetween2countries approximation IFE GraphicAnalysisoftheInternationalFisherEffect IFE a PointsontheIFELineb PointsbelowtheIFELinec PointsabovetheIFELine IFE IllustrationofIFELine WhenExchangeRateChangesPerfectlyOffsetInterestRatesDifferentials IFELine IFE IFE WhytheinternationalFisherEffectDoesNotOccur InrealitycurrencywithhighinterestratesmightstrengthenduetoinflowoffundInvestorsmightnotbelievethathighinterestrateisd