1、Relationship Between Inflation, Interest Rates and Exchange Rates Learning OutcomesLearning outcomes for Lecture 7: A. Discuss the purchasing power parity (PPP) theory and its implications for exchange rate changesB. Discuss the International Fisher effect (IFE) theory and its implications for excha

2、nge rate changesC. Compare the PPP theory, the IFE theory, and the theory of interest rate parity (IRP), which was introduced in the previous chapterPurchasing Power Parity (PPP)1. Interpretations of Purchasing Power Paritya. Absolute Form of PPP: It suggests that prices of the same basket of produc

3、ts in 2 different countries should be equal when measure in a common currency. Realistically, the existence of transportation costs, tariffs and quotas prevent absolute PPPb. Relative Form of PPP: State that the rate of change in the prices of the baskets should be somewhat similar when measured in

4、a common currency, as long as transportation costs and trade barriers are unchanged Relative PPP2. Rationale behind Purchasing Power Parity Theory:Exchange rate adjustment is necessary for the relative purchasing power to be the same whether buying products locally or from another countryAppreciatio

5、n/Depreciation of future exchange rate = Inflation differentialRefer to e.g. in p.234Derivation of PPPlef = (1+Ih)/(1+If) 1lef = % change in foreign currencylIh = Inflation of home countrylIf = Inflation of foreign country lThe formula reflects the relationship between relative inflation rates and e

6、xchange rates according to PPPlIf Ih If, ef is positive, foreign currency will appreciatel If Ih iF, ef will be positive because the relatively low foreign interest rate reflects low inflationary expectations in the foreign country, foreign currency will appreciate (forward premium) liH iF, ef will

7、be negative because the relatively high foreign interest rate reflects high inflationary expectations in the foreign country, foreign currency will depreciate (forward discount) IFElRefer to Exhibit 8.6 p.247 for summary of IFElRefer to p.246-247 for e.g. lSimplified relationship:lef = iH iF, that i

8、s the percentage change in exchange rate over the investment horizon will equal interest rates differentials between 2 countries, approximation IFEGraphic Analysis of the International Fisher Effect (IFE)a. Points on the IFE Lineb. Points below the IFE Linec. Points above the IFE LineIllustration of

9、 IFE Line (When Exchange Rate Changes Perfectly Offset InterestRates Differentials)IFElWhy the international Fisher Effect Does Not Occur:lIn reality currency with high interest rates might strengthen due to inflow of fundlInvestors might not believe that high interest rate is due to higher expected

10、 inflation ratelCentral bank increase interest rate to cool down economy or attract inflow of fundslDepends on the countrys foreign reserves: China ComparisonSummaryTheoryKey VariablesSummaryIRPForward rate premium/discount and interest rate differentialsThe forward rate of one currency with respect to another will contain premium or discount that is determined by interest rate differential. PPP% in spot rate and inflation differentialThe spot rate of one currency with respect to another will change in reaction to inflatio