Relationships between Inflation, Interest Rates, and Exchange Rates CHAPTER 8 Relationships between Inflation, Interest Rates, and Exchange Rates © 2000 South-Western College Publishing 1

Chapter Objectives To explain the purchasing power parity (PPP) theory and its implications for exchange rate changes; To explain the international Fisher effect (IFE) theory and its implications for exchange rate changes; and To compare the PPP theory, IFE theory, and theory of interest rate parity (IRP).

Purchasing Power Parity When a country’s inflation rate rises relatively, decreased exports and increased imports depress the country’s currency. The theory of purchasing power parity (PPP) focuses on this inflation - exchange rate relationship. The absolute form is the “law of one price.” It suggests that similar products in different countries should be equally priced when measured in the same currency. The relative form of PPP accounts for market imperfections like transportation costs, tariffs, and quotas.

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Purchasing Power Parity absolute versjon Assume the following: S = spot rate Pnok = price in Norway Pusd = price in the US S = Pnok/Pusd A Big Mac costs 34 kr or 2.54 $, what is the spot exchange rate ? S = 34/2.54 = 13,39 kr/$

Purchasing Power Parity Actual exchange rate ca 8,86 Big Mac cost in $ is 34/8,86 = 3,84$, while US price is 2,54$ PPP exchange rate is as we have seen 13,39 Norwegian kroner are overvalued by 13,39/8,86 - 1= 51,1 %

Purchasing Power Parity Let`s use the following symbols I = inflation IN = inflation i Norway IEU = inflation in Euroland S0 = spotrate now St = expected spot rate at time t

Purchasing Power Parity

Purchasing Power Parity When inflation occurs and PPP holds, the exchange rate will adjust to maintain the parity: Pf (1 + If ) (1 + ef ) = Ph (1 + Ih ) where Ph = price index of goods in the home country Pf = price index of goods in the foreign country Ih = inflation rate in the home country If = inflation rate in the foreign country ef = % change in the foreign currency’s value Since Ph = Pf , solving for ef gives: ef = (1 + Ih ) _ 1 (1 + If )

Purchasing Power Parity The relationship can be simplified as follows: ef » Ih _ If This formula is appropriate only when the inflation differential is small. Suppose that the inflation rate in U.S. is 9%, while U.K.’s rate is 5%. Then PPP suggests that the £ should appreciate by about 4%. U.S. will import more, while U.K. will import less, until the £ has risen by about 4%. At this point, U.K. goods will cost 5+4=9% more to U.S. consumers, while U.S. goods will cost 9-4=5% more to U.K. consumers.

Graphic Analysis of Purchasing Power Parity Inflation Rate Differential (%) home inflation rate - foreign inflation rate %D in the foreign currency’s spot rate - 2 - 4 2 4 1 3 - 1 - 3 PPP line

Graphic Analysis of Purchasing Power Parity Inflation Rate Differential (%) home inflation rate - foreign inflation rate 4 PPP line Increased purchasing power of foreign goods 2 - 3 - 1 1 3 %D in the foreign currency’s spot rate Decreased purchasing power of foreign goods - 2 - 4

Purchasing Power Parity If the actual inflation differential and exchange rate % change for two or more countries deviate significantly from the PPP line over time, then PPP does not hold. A statistical test can be developed by applying regression analysis to the historical exchange rates and inflation differentials: ef = a0 + a1 { (1+Ih)/(1+If) - 1 } + m The appropriate t-tests are then applied to a0 and a1, whose hypothesized values are 0 and 1 respectively.

Purchasing Power Parity PPP may not occur consistently due to: the existence of other influential factors like differentials in income levels and risk, as well as government controls; and the lack of substitutes for traded goods. A limitation in testing PPP is that the results may vary according to the base period used. PPP can also be tested by assessing a “real” exchange rate over time. If this rate reverts to some mean level over time, this would suggest that it is constant in the long run.

International Fisher Effect According to the Fisher effect, nominal risk-free interest rates contain a real rate of return and an anticipated inflation. If the same real return is required across countries, differentials in interest rates may be due to differentials in expected inflation. According to PPP, exchange rate movements are caused by inflation rate differentials. The international Fisher effect (IFE) theory suggests that currencies with higher interest rates will depreciate because the higher rates reflect higher expected inflation.

International Fisher effekt Let`s combine FE and PPP PPP – exchange rates affected by inflation FE – inflation affects nominal interest tates Let`s use the following symbols ih = nominal interest in the home country if = nominal interest in the foreign country S0 = spotrate now St = expected spot rate at time t

International Fisher Effect According to the IFE, the expected effective return on a foreign investment should equal the effective return on a domestic investment: (1 + if ) (1 + ef ) _ 1 = ih where ih = interest rate in the home country if = interest rate in the foreign country ef = % change in the foreign currency’s value Solving for ef : ef = (1 + ih ) _ 1 (1 + if ) The simplified form, ef » ih _ if , provides reasonable estimates when the interest rate differential is small.

International Fisher effect IFE says that

International Fisher Effect Japan U.S. Canada Investors Residing in Attempt to Invest in ih Return in Home Currency Real Earned if ef Ih 5 8 13 - 3 - 8 3 - 5 6 11 2 %

Graphic Analysis of the International Fisher Effect Interest Rate Differential (%) home interest rate - foreign interest rate - 2 - 4 2 4 1 3 - 1 - 3 IFE line Lower returns from investing in foreign deposits %D in the foreign currency’s spot rate Higher returns from investing in foreign deposits

International Fisher Effect While the IFE theory may hold during some time frames, there is evidence that it does not consistently hold. A statistical test can be developed by applying regression analysis to the historical exchange rates and nominal interest rate differentials: ef = a0 + a1 { (1+ih)/(1+if) - 1 } + m The appropriate t-tests are then applied to a0 and a1, whose hypothesized values are 0 and 1 respectively.

International Fisher Effect Since the IFE is based on PPP, it will not hold when PPP does not hold. According to the IFE, the high interest rates in southeast Asian countries before the Asian crisis should not attract foreign investment because of exchange rate expectations. However, since narrow bands were being maintained by some central banks, some foreign investors were motivated. Unfortunately for these investors, the efforts made to stabilize the currencies were overwhelmed by market forces.

Comparison of IRP, PPP, and IFE Theories Forward Rate Discount or Premium Exchange Rate Expectations Inflation Rate Differential Interest Rate Interest Rate Parity (IRP) Fisher Effect International Fisher Effect (IFE) Purchasing Power Parity (PPP)

Impact of Inflation on an MNC’s Value Effect of Inflation E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = the weighted average cost of capital of the U.S. parent

Chapter Review Purchasing Power Parity (PPP) Derivation of PPP Rationale Behind PPP Theory Graphic Analysis of PPP Testing the PPP Theory Why PPP Does Not Occur Limitation in Tests of PPP PPP in the Long Run

Chapter Review International Fisher Effect (IFE) Derivation of the IFE Graphic Analysis of the IFE Tests of the IFE Why the IFE does Not Occur Application of the IFE to the Asian Crisis Comparison of IRP, PPP, and IFE Theories Impact of Foreign Inflation on the Value of the MNC