Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates Flashcards
What is the purchasing power parity (PPP) theory?
theory suggesting that exchange rates will adjust over time to reflect the differential in inflation rates in the two countries
- purchasing power of consumers when purchasing domestic goods will be the same as that when they purchase foreign goods.
2 interpretations:
Absolute form
Relative form
What is the absolute form of PPP?
theory that explains how inflation differentials affect exchange rates. It suggests that prices of two products of different countries should be equal when measured by a common currency.
Unrealistic due to
a. Transportation costs
b. Tariffs
consumers shift demand to lowest prices - shift until downward pressure on home currency = lower inflation in foreign offset by strengthening of foreign currency
What is the relative form of PPP?
rate of change in prices (inflation) and exchange rates, focusing on how inflation differences affect exchange rate movements over time.
○ Assume transport costs and market imperfections remain same
If US inflation is 5% and foreign is 1%, what should happen according to PPP
What if US inflation is 2% and foreign is 7%
a. currency should appreciate to offset pricing dif. 5-1 = 4% appreciate
b. foreign depreciate by 5%
When inflation is high (local) what happens to imports/exports and currency?
Exports decrease, imports increase, local currency depreciate by inflation diff.
When inflation is low (local) what happens to imports/exports and currency?
Exports increase, imports decrease, local currency appreciate by inflation diff.
What is the PPP line?
diagonal line on a graph that reflects points at which the inflation differential between two countries is equal to the percentage change in the exchange rate between the two respective currencies.
Ih - If -> if pos = app , if neg = dep
points off the line - PP disparity
Why are their deviations from PPP
a. Confounding effects: change in a country’s spot rate is driven by more than the inflation differential between two countries
inflation, interest, income level, gov controls, future exchange rates
b. No substitutes for traded products
What is the international Fisher effect (IFE) theory?
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
Fisher effect
Nominal interest = Real interest + expected inflation rate
If real rate 2% (US and CAD) nominal rate 8% CAD + 5% US, what happens to exchange rate
Inflation CAD = 8 - 2 = 6%
Inflation USD = 5 - 2 = 3%
Home - foreign = 3 - 6 = -3 (foreign depreciate)
IFE line (above, below, on) meaning
On the line; exchnage rate adjustments offset interest rate diff (same yield)
Below/right of line: higher returns from investing in foreign deposits.
Above the IFE line generally reflect returns from foreign deposits that are lower than the returns possible domestically.
High local interest = ___ inflation = ___ imports/exports = currency ___
high local inflation
imports increase, exports decrease
local currency depreciate by inflation difference
Example IFE: Non US currency
Nominal Interest: 8% Canada, 3% Japan
Real interest: 2% both
what happens to currency
a. Calculate Inflation: 6% can , 1% jap
b. Apply PPP
a. 6% - 1% = 5%
b. Canadian depreciate by 5% vs yen (japan), offset
Depreciation (less amount when convert) of currency will offset the interest difference
Example IFE: Foreign investors
Nominal Interest: 5% home, 3% foreign
Real interest: 2% both
a. Calculate Inflation: 3% US , 1% foreign
b. Apply PPP
a. 3% US - 1% foreign = 2% foreign appreciate
Appreciation of currency will offset the interest difference
