Relationships among inflation, interest rates and exchange rates

Question 1

What is purchasing power parity

Answer 1

Purchasing power parities (PPPs) are the rates of currency conversion that try to equalise the purchasing power of different currencies, by eliminating the differences in price levels between countries.

Question 2

What is absolute Form of PPP

Answer 2

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.

Question 3

What is relative form of PPP

Answer 3

Due to market
imperfections, 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 4

What is the rationale for PPP theory? Why does it work

Answer 4

Exchange rate adjustment is necessary for the
relative purchasing power to be the same
whether buying products locally or from abroad.
If the purchasing power is not equal, consumers
will shift purchases to wherever products are
cheaper until the purchasing power is equal.

Question 5

What is the equation to express the relationship according to PPP between relative inflation rates and the exchange rate

Answer 5

ef=((1+Ih)/(1+If))-1
I - inflation rate of home and foreign
e - exchange rate adjustment

Question 6

What is the simplified expression to estimate the PPP relationship?

Answer 6

ef=Ih-If
Approximately

Question 7

What happens according to PPP if you have relatively high local inflation

Answer 7

Imports will increase, exports will decrease and local currency should depreciate by same degree as inflation differential

Question 8

What happens according to PPP if you have relatively low local inflation

Answer 8

Imports will decrease, exports will increase and so local currency should appreciate by the same degree as inflation differential

Question 9

What happens according to PPP if local and foreign inflation rate are similar?

Answer 9

No impact on import and export volumes and local currency value is not affected

Question 10

What does the graphical illustration of PPP look like

Answer 10

% change in foreign currencys spot rate is plotted on x axis.
Ih-If (%) is plotted ont he y axis.
PPP line is drawn where X=Y

Question 11

How can the graphical representation of PPP be interrpretted?

Answer 11

The points on the line 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
Any points off of the PPP line represent purchasing
power disparity. As rate does not move as PPP theory suggests.

Question 12

What does PP disparity mean?

Answer 12

If the exchange rate does not move as PPP theory suggests, there is a disparity in the purchasing power of the two countries

Question 13

Detail a simple test for purchasing power parity theory

Answer 13

Choose two countries and compare the differential in their inflation rates to the percentage change in the foreign currency’s value during several time periods

Question 14

Detail statistical test that can be carried out for testing purchasing power parity theory

Answer 14

Statistical Test - Apply regression analysis to historical exchange rates and inflation differentials.
Results of Statistical Tests of PPP- Deviations from PPP are not as pronounced for longer
time periods, but they still exist. Thus, reliance on PPP to derive a forecast of the exchange rate is subject to significant error.

Question 15

What is the hypothesis test for purchasing power parity

Answer 15

Regression test where test if coefficients are signifiant:
Test for a0=0, a1=1

Question 16

What is the test statistic for the two hypothesis tests for purchasing power parity

Answer 16

t=a0-0/SE of a0
or
t=a1-1/SE of a1

both t values

Question 17

What are the limitations of testing the purchasing power parity

Answer 17

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 PPP.

Question 18

Why would purchasing power parity not hold?

Answer 18

A change in a country’s spot rate is driven by more than
the inflation differential between two countries.
No substitutes for traded goods/imports

Question 19

What factors influence the countries spot rate

Answer 19

Change in differential between domestic inflation and foreign inflation
Change in differential between domestic interest and foreign interest rates
Change in differential between domestic income and foreign income elvels
Change in government controls
Change in expectations of future exchange rates

Question 20

Explain the international fisher effect IFE

Answer 20

The International Fisher Effect (IFE) is a hypothesis in international finance that suggests differences in nominal interest rates reflect expected
changes in the spot exchange rate between countries. It states that a spot exchange rate is expected to change equally in the opposite direction of the interest
rate differential. The currency of the country with the higher nominal
interest rate is expected to depreciate against the
currency of the country with the lower rate

Question 21

What does IFE suggest the nominal interest rate is made up of

Answer 21

Real rate of interest = Nominal interest rate - Expected inflation rate

where real rate of interest is return after accounting for expected inflation

Question 22

What are the steps to using IFE to predict exchange rate movements?

Answer 22

Apply the Fisher Effect to Derive Expected Inflation
per Country
Rely on PPP to Estimate the Exchange Rate
Movement in response to those expected
inflation rates of the two countries.

Question 23

What are the implications of the IFE

Answer 23

IFE theory suggests
that currencies with high interest rates will have high expected inflation (due to fisher) and the relatively high inflation will cause the currencies to depreciate ( due to ppp) The exchange rate
effect could offset the interest rate advantage
According to the IFE, the expected return is the same irrespective of where the investors of a
given country invest their funds.

Question 24

How does one graphically illustrate the IFE line when exchange rate
changes perfectly offset interest rate differentials)
Relationships among inflation and rates

Answer 24

X axis: % change in the foreign currency spot rate
Y axis: ih-if (%)
IFE line is drawn where X=Y

Question 25

How to interpret IFE line graph

Answer 25

Points on the IFE 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 IFE Line - Reflect the higher
returns from investing in foreign deposits.
Points above the IFE Line
- reflect returns from
foreign deposits that are lower than the returns possible domestically.
Relationships among inflation and rates

Question 25

How can you test international fisher effect using a scatterplot?

Answer 25

Interest rates and exchange rate changes were plotted over
time on a graph.
If points are systematically below IFE line - higher returns from foreign investing
If points are systematically above IFE line - lower returns from foreign investing
On both sides of line - balance across periods.

Question 26

What sort of statistical tests for international fisher effect is there

Answer 26

Apply regression analysis to historical exchange rates
and the nominal interest rate differential.
Relationships among inflation and rates
same as before

Question 27

What are the limitations of Fisher effect

Answer 27

The difference between the nominal interest rate and actual inflation rate is not consistent. Thus, while the Fisher effect can effectively use nominal interest rates to
estimate the market’s expected inflation over a particular period, the market may be wrong. Also PPP theory limitations too! 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 28

Compare IFE theory to reality

Answer 28

The IFE 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.
IFE 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.
Whether the IFE holds in reality is dependent on the countries involved and the period assessed.

Question 29

Compare IRP, PPP, IFE

Answer 29

IRP 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.
▪ PPP and IFE focus on how a currency’s spot rate will
change over time.
▪ Whereas PPP suggests that the spot rate will change in accordance with inflation differentials, IFE suggests that it will change in accordance with interest rate differentials.
PPP is related to IFE because expected inflation differentials influence the nominal interest rate differentials between two countries.