Chapter 8 - Relationships among Inflation, Interest Rates and Exchange Rates

Question 1

Chapter Objectives:

Answer 1

Explain the purchasing power parity (PPP) theory and its implications for exchange rate changes.

Explain the International Fisher effect (I F E) theory and its implications for exchange rate changes.

Question 2

Purchasing Power Parity (P P P)

Answer 2

Inflation rates and interest rates can have a significant impact on exchange rates and, therefore, can influence the value of multinational corporations (MNCs).

Financial managers of MNCs must understand how inflation and interest rates can affect exchange rates so that they can anticipate how their MNCs may be affected.

Note: Recall that when a country’s inflation rate rises, the demand for its exports declines as the inflated prices of its products encourage foreign buyers to purchase substitute products at home or in other countries.
In addition, consumers and firms in the country with high inflation increase their importing for the same reason.
Both of these forces place downward pressure on the high-inflation country’s currency.
Purchasing power parity (PPP) theory supports the notion that relatively high inflation places downward pressure on a currency’s value

Question 3

One of the most popular and controversial theories in international finance is _____, which attempts to quantify the relationship between inflation and the exchange rate.

Answer 3

purchasing power parity (PPP) theory

Question 4

Interpretations of Purchasing Power Parity:

Answer 4

Absolute Form of P P P: Without international barriers, consumers shift their demand to wherever prices are lower. That shift will continue until downward pressure on the home country currency becomes sufficient that the lower inflation in the foreign country is offset by the strengthening of the foreign currency. Prices of the same basket of products in two different countries should be equal when measured in common currency.

Relative Form of P P P: Due to market imperfections (e.g. country-specific transportation costs and taxes), prices of the same basket of products in different countries will not necessarily be the same, but the rate of change in prices should be similar when measured in common currency

Question 5

Derivation of Purchasing Power Parity:

Answer 5

Relationship between relative inflation rates (I) and the percentage change of exchange rate (e).

ef= [(1+ Ih) / (1+If)]- 1

If Ih>If then, ef should be positive, this implies that the foreign currency will appreciate when the home country’s inflation exceeds the foreign country’s inflation.

If Ih<If then, ef should be negative, this implies that the foreign currency will depreciate when the foreign country’s inflation exceeds the home country’s inflation.

Question 6

Using P P P to Estimate Exchange Rate Effects

Answer 6

The relative form of P P P can be used to estimate how an exchange rate will change in response to differential inflation rates between countries.

International trade is the mechanism by which the inflation differential affects the exchange rate according to this theory (Exhibit 8.1)

A simplified, but less-precise relationship based on PPP is: ef =(approx) Ih - If

The percentage change in the exchange rate should be approximately equal to the difference in inflation rates between the two countries.

This simplified formula is appropriate only when the inflation differential is small or when the value of If is close to zero.

Question 7

Graphic Analysis of Purchasing Power Parity

Answer 7

Using P P P theory, we should be able to assess the potential impact of inflation on exchange rates. The points on Exhibit 8.2 suggest that given an inflation differential between the home and the foreign country of X percent, the foreign currency should adjust by X percent due to that inflation differential.

P P P Line — The diagonal line connecting all these points together.

Question 8

Exhibit 8.2 Illustration of Purchasing Power Parity and Disparity

Answer 8

-The diagonal line connecting all these points together is known as the purchasing power parity (PPP) line.

-If the exchange rate does, in fact, respond to inflation differentials, as PPP theory suggests, then the actual points should lie on or close to the PPP line.

Question 9

Points above the PPP line for domestic consumers:

Answer 9

Increased Purchasing Power when buying foreign products

Question 10

Points below the PPP line for domestic consumers:

Answer 10

Reduced Purchasing power when buying foreign products

Question 11

Graphic Analysis of Purchasing Power Parity (continued)
Purchasing Power Disparity

Answer 11

Any points off of the P P P line represent purchasing power disparity. If the exchange rate does not move as P P P theory suggests, there is a disparity in the purchasing power of the two countries.

Point C in Exhibit 8.2 represents a situation where home inflation (I h) exceeds foreign inflation (I f ) by 4%. Yet, the foreign currency appreciated by only 1% in response to this inflation differential. Consequently, purchasing power disparity exists.

Question 12

Testing the Purchasing Power Parity Theory

Answer 12

Simple test of P P P:
Choose two countries (such as the United States and a foreign country) and compare the differential in their inflation rates to the percentage change in the foreign currency’s value during several time periods. This simple test of P P P is applied to four different currencies from a U.S. perspective in Exhibit 8.3.

Statistical Test of P P P:
A simplified statistical test of PPP can be developed by applying regression analysis to historical exchange rates and inflation differentials

Results of Statistical Tests of P P P:
Deviations from P P P are not as pronounced for longer time periods, but they still exist. Thus, reliance on P P P to derive a forecast of the exchange rate is subject to significant error, even when applied to long-term forecasts.

Question 13

Exhibit 8.3 Comparison of Annual Inflation Differentials and Exchange Rate Movements for Four Major Countries

Answer 13

-most of the points would be quite close to the horizontal axis, but spread wide to the left and right of the vertical axis.

-in such a case, the percentage changes in exchange rates are typically much more pronounced than the inflation differentials

-Thus, exchange rates commonly change to a greater extent than PPP theory would predict.

Question 14

Limitation of P P P Tests

Answer 14

Results vary with the base period used. The base period chosen should reflect an equilibrium position since subsequent periods are evaluated in comparison to it. If a base period is used when the foreign currency was relatively weak for reasons other than high inflation, most subsequent periods could show higher appreciation of that currency than what would be predicted by P P P.

Question 15

Why Purchasing Power Parity Does Not Hold

Answer 15

1. Confounding effects: A change in a country’s spot rate is driven by more than the inflation differential between two countries:

ef = f (ΔI N F, ΔI N T, ΔINC, ΔGC, ΔEXP )

where
ef = percentage change in the spot rate
ΔINF = change in the differential between U. S. inflation and the foreign country’s inflation
ΔINT = change in the differential between the U.S. interest rate and the foreign country’s interest rate
ΔINC = change in the differential between the U.S. income level and the foreign country’s income level
ΔGC = change in government controls
ΔEXP = change in expectations of future exchange rates

Since the exchange rate movement is not driven solely by ΔI N F, the relationship between the inflation differential and exchange rate movement cannot be as simple as the P P P theory suggests.

2. No Substitutes for Traded Goods

The idea behind PPP theory is that, as soon as prices become relatively higher in one country, consumers in the other country will stop buying imported products and instead purchase domestic products that serve as substitutes.

This shift, in turn, will affect the exchange rate.

However, if substitute products are not available domestically, then consumers will probably continue to buy the imported products

Question 16

International Fisher Effect (I F E)

Answer 16

-According to PPP theory, exchange rates respond to the difference in actual inflation rates of countries over a given period.
-However, because the actual inflation rates are not known until the period is over, they cannot be used to anticipate how exchange rates might change in that period.
-Another theory, known as theinternational Fisher effect (IFE) theory, identifies a specific relationship between the differential in nominal interest rates of two countries at the beginning of a period and the expected exchange rate movement over that period.
- It suggests
*how each country’s nominal interest rate can be used to derive its expected inflation rates and
*how the difference in expected inflation rates between two countries signals an expected change in the exchange rate.

Fisher effect:
Suggests that the nominal interest rate contain two components:
1. Expected inflation rate
2. Real interest rate
The real rate of interest represents the return on the investment to savers after accounting for expected inflation.

Question 17

Deriving a Country’s Expected Inflation Rate

Answer 17

The nominal interest rate that is offered on savings deposits represents the return to local savers, and that rate should exceed the expected inflation rate if the goal is to attract savings. This implies that the real (inflation-adjusted) interest rate should be positive:

Real interest rate = (Nominal interest rate − Expected inflation rate)>0
Nominal interest rate=Real interest rate + Expected inflation rate

By rearranging terms, the Expected inflation rate can be derived as follows:
–> Expected inflation rate = Nominal interest rate − Real interest rate

Question 18

Deriving a Country’s Expected Inflation Rate

Answer 18

Expected Inflation differential = iA-iB

This formula is very powerful because it suggests that if the real interest rate required by savers is similar across countries, then the difference between the expected inflation rates of two countries can be derived simply from the difference between their respective nominal interest rates

Question 19

Estimating the Expected Exchange Rate Movement

Answer 19

Once the expected inflation rates of two countries have been derived from the nominal interest rates (based on the international Fisher effect) as just described, P P P theory can be applied to estimate how the expected inflation rate differential will affect exchange rates.

Question 20

Implications of the International Fisher Effect

Answer 20

The international Fisher effect (I F E) theory suggests that currencies with high interest rates will have high expected inflation (due to the Fisher effect) and the relatively high inflation will cause the currencies to depreciate (due to the P P P effect).

Question 21

Implications of the I F E for Foreign Investors

Answer 21

The implications are similar for foreign investors who attempt to capitalize on relatively high U.S. interest rates. The foreign investors will be adversely affected by the effects of a relatively high U.S. inflation rate if they try to capitalize on the high U.S. interest rates since USD will depreciate and offset the interest rate differential.

Question 22

Implications of the I F E for Two Non-U.S. Currencies

Answer 22

The I F E theory can be applied to any exchange rate, even exchange rates that involve two non-U.S. currencies. (Exhibit 8.4)

Question 23

Implications of Using an Alternative Assumed Real Interest Rate

Answer 23

As long as the real interest rates are assumed to be the same for the two countries of interest, the difference in expected inflation rates can be derived simply from the difference in nominal interest rates between the two countries, and the conclusions would remain the same.

Question 24

Implications of an Imperfect Offsetting Effect

Answer 24

According to I F E theory, over the course of several periods the exchange rate effect should fully offset the interest rate advantage on average.

Question 25

Exhibit 8.3 Summary of Application of the International Fisher Effect from to Three Different Investment Scenarios

Answer 25

According to IFE:
Japanese investor invests in U.S. Savings deposit
Column (2): INTus-INTjp=5%-3%=2%
Column (3): According to Fisher Effect: Expected inflation rate = Nominal interest rate − Real interest rate
E(INFus)=5%-2%=3% E(INFjp)=3%-2%=1%
E(INFus)-E(INFjp)=3%-1%=2%
Column (4): According to PPP:
E(INFjp)-E(INFus)=1%-3%=-2%
Column (5): INTus + e% of usd=5%-2%=3%
Column (6): 3% for Japanese investors who invest in savings deposit in Japan
Therefore, Japanese investors will not benefit by investing in U.S. although the U.S. interest rate is higher

Question 26

Derivation of the International Fisher Effect

Answer 26

Relationship between the interest rate (i) differential between two countries and expected exchange rate (e)

ef= [(1+ Ih) / (1+If)]- 1

Question 27

Derivation of the International Fisher Effect (continued)
Numerical example based on derivation of the I F E

Answer 27

Assume that the interest rate on a one-year insured home country bank deposit is 11%, and the interest rate on a 1-year insured foreign bank deposit is 12%. For the actual returns of these two investments to be similar from the perspective of investors in the home country, the foreign currency would have to change over the investment horizon by the following percentage:

Question 28

Exhibit 8.5 Summary of International Fisher Effect - Scenario 1

Question 29

Exhibit 8.5 Summary of International Fisher Effect - Scenario 2

Question 30

Derivation of the International Fisher Effect (continued)
–> Simplified relationship

Answer 30

ef =(approx) ih-if

Question 31

Exhibit 8.6 Illustration of I F E Line (When Exchange Rate Changes Perfectly Offset Interest Rate Differentials)

Answer 31

For points on IFE: This means that when accounting for the exchange rate movements, investors will end up achieving the same return (yield) whether they invest at home or in a foreign country.

Points above the IFE line generally reflect returns from foreign deposits that are lower than the returns that are possible domestically

Points below the IFE line generally reflect higher returns from investing in foreign deposits

Question 32

Points above the IFE line

Answer 32

generally reflect returns from foreign deposits that are lower than the returns that are possible domestically

Question 33

Points below the IFE line

Answer 33

generally reflect higher returns from investing in foreign deposits

Question 34

Graphic Analysis of the International Fisher Effect

Answer 34

Point E in Exhibit 8.6 reflects a situation where the foreign interest rate exceeds the home interest rate by three percentage points. The foreign currency has depreciated by 3% to offset its interest rate advantage.

Point F represents a home interest rate 2% above the foreign interest rate. I F E theory suggests that the foreign currency should appreciate by 2% to offset the interest rate disadvantage.

Point F illustrates the I F E from a foreign investor’s perspective. The home interest rate will appear attractive to the foreign investor. However, I F E theory suggests that the foreign currency will appreciate by 2%.

Question 35

Graphic Analysis of the International Fisher Effect (continued)

Answer 35

Points on the I F E Line:
All the points along the I F E line reflect exchange rate adjustments to offset the differential in interest rates. This means investors will end up achieving the same yield (adjusted for exchange rate fluctuations) whether they invest at home or in a foreign country.

Points below the I F E Line:
Points below the I F E line generally reflect the higher returns from investing in foreign deposits.

Points above the I F E Line:
Points above the I F E line generally reflect returns from foreign deposits that are lower than the returns possible domestically.

Question 36

Testing the International Fisher Effect

Answer 36

If the actual points (one for each period) of interest rates and exchange rate changes were plotted over time on a graph, we could determine whether:

the points are systematically below the I F E line (suggesting higher returns from foreign investing),

the points are systematically above the IFE line (suggesting lower returns from foreign investing), or

evenly scattered on both sides (suggesting a balance of higher returns from foreign investing in some periods and lower foreign returns in other periods).

Question 37

Testing the International Fisher Effect
: Statistical Test of the I F E

Answer 37

A statistical test of the I F E can be developed by applying regression analysis to historical exchange rates and the nominal interest rate differential:

a0 is a constant
a1 is the coefficient’s slope
μ is an error term

Question 38

Limitations of the I F E

Answer 38

The I F E theory relies on the Fisher effect and P P P

Question 39

Limitation of the Fisher Effect

Answer 39

The IFE relies on its estimated expected inflation differential between the two countries to estimate the expected exchange rate movement, but the expected inflation differential is subject to error (that is, it might not properly estimate the actual inflation differential for the period). If the variable that the IFE uses to make a prediction is inaccurate, the prediction derived from this variable may be inaccurate as well.

Question 40

Limitation of P P P

Answer 40

Other country characteristics besides inflation (income levels, government controls) can affect exchange rate movements. Even if the expected inflation derived from the Fisher effect properly reflects the actual inflation rate over the period, relying solely on inflation to forecast the future exchange rate is subject to error.

Question 41

I F E Theory versus Reality

Answer 41

The I F E theory contradicts how a country with a high interest rate can attract more capital flows and therefore cause the local currency’s value to strengthen (Ch. 4).

I F E theory also contradicts how central banks may purposely try to raise interest rates in order to attract funds and strengthen the value of their local currencies (Ch. 6).

Whether the I F E holds in reality is dependent on the countries involved and the period assessed.

The I F E theory may be especially meaningful to situations in which the M N Cs and large investors consider investing in countries where the prevailing interest rates are very high.

Question 42

Comparison of the I R P, P P P, and I F E

Answer 42

Although all three theories relate to the determination of exchange rates, they have different implications. (Exhibit 8.7)

I R P focuses on why the forward rate differs from the spot rate and on the degree of difference that should exist. It relates to a specific point in time.

P P P and I F E focus on how a currency’s spot rate will change over time.

Whereas P P P suggests that the spot rate will change in accordance with inflation differentials, I F E suggests that it will change in accordance with interest rate differentials.