© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. International Financial Management Abridged 10 th Edition by Jeff Madura 1

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 8 Relationships among Inflation, Interest Rates and Exchange Rates Chapter Objectives This chapter will: A. Explain the purchasing power parity (PPP) theory and its implications for exchange rate changes B. Explain the International Fisher effect (IFE) theory and its implications for exchange rate changes C. Compare the PPP theory, the IFE theory, and the theory of interest rate parity (IRP), which was introduced in the previous chapter 2

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Purchasing Power Parity (PPP) 1.Interpretation of Purchasing Power Parity a.Absolute Form of PPP: without international barriers, consumers shift their demand to wherever prices are lower. Prices of the same basket of products in two different countries should be equal when measured in common currency. b.Relative Form of PPP: Due to market imperfections, prices of the same basket of products in different countries will not necessarily be the same when measured in a common currency. However, the rate of change in prices should be somewhat similar when measured in common currency as long as transportation costs and trade barriers are unchanged.

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Purchasing Power Parity 1.Relationship between relative inflation rates (I) and the exchange rate (e). 2.Simplified PPP relationship

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 Exhibit 8.1 Summary of Purchasing Power Parity

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Exhibit 8.2 Illustration of Purchasing Power Parity 6

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Exhibit 8.3 Identifying Disparity in Purchasing Power 7

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Testing the Purchasing Power Parity Theory 1.Conceptual tests of PPP 2.Statistical Test of PPP 3.Results of Tests of PPP 4.Tests of PPP for each currency 5.Limitation of PPP Tests

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Exhibit 8.4 Comparison of Annual Inflation Differentials and Exchange Rate Movements For Four Major Currencies 9

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Why Purchasing Power Parity Does Not Occur 1.Confounding effects 2.No substitutes for traded goods

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 International Fisher Effect (IFE) 1.IFE suggests that the nominal interest rate contain two components: a.Expected inflation rate b.Real interest rate 2.Implications of the IFE: currencies with high interest rates will have high expected inflation and will be expected depreciate. 3.Implications of the IFE for foreign investors: foreign investors will be adversely affected by the effects of relatively high U.S. inflation rate if they try to capitalize on high U.S. interest rates.

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 Derivation of the International Fisher Effect 1.Relationship between the interest rate (i) differential between two countries and expected exchange rate (e) 2.Simplified relationship

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 Exhibit 8.6 Summary of the International Fisher Effect 13

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 Exhibit 8.7 Illustration of IFE Line (When Exchange Rate Changes Perfectly Offset Interest Rates Differentials) 14

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 Exhibit 8.9 Comparison of the IRP, PPP, and IFE Theories 15