Topic 4 - Burgernomics, PPP and The Fisher Effect

Question 1

What is PPP?

Answer 1

Purchasing Power Parity
- Absolute PPP: Without international barriers, consumers shift demand to wherever prices are lower. Prices of the same basket of products in two different countries should be equal.
- Relative PPP: Due to market imperfections, prices of the same basket of products in different countries will not necessarily br the same, but the rate of change in prices should be similar (when measured in common currency ie. USD).

Question 2

What does the below forumla solve?

Answer 2

Purchasing Power Parity
- Relationship between relative inflation rates (I) and the exchange rate (e).

Question 3

What does the below formula solve? (FX)

Answer 3

Using PPP to Estimate Exchange Rate Effects
- The relative form of PPP can be used to estimate how an exchange rate will change in response to differential inflation rates between countries
- The percentage change in the exchange rate should be approximately equal to the difference in inflation rates between the two countries

Question 4

If their is relatively low local inflation, what effect with that have on imports and exports?

Answer 4

Imports will decrease and exports will increase

Question 5

PPP

On the below graph, what do A and B represent?

Answer 5

A and B represent the currency exchange values between 2 currencies.
- The currencies are in Parity as they are on the diagonal PPP line
- Any points off of the PPP line represent purchasing power disparity. If the exchange rate does not move as PPP theory suggests, there is a disparity in the purchasing power of the two countries

Question 6

PPP

What situation does the graph show?

Answer 6

Point C in Exhibit 6.3 represents a situation where home inflation (Ih) exceeds foreign inflation (If ) by 4 per cent. Yet, the foreign currency appreciated by only 1 per cent in response to this inflation differential. Consequently, purchasing power disparity exists

Question 7

Simple Test and Statistical Test are both ways of testing ——–

Answer 7

Simple test of PPP
- 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

Statistical Test of PPP
- Apply regression analysis to historical exchange rates and inflation differentials
- 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, even when applied to long-term forecasts

Question 8

PPP

True or False:
Government controls, income levels, expectations of future exchange rates, interest rates and inflation rates are all effect interest rates?

Answer 8

True
- These are called ‘Confounding Effects’
- This is one set of factors that explan why PPP is not held over the long term

Question 9

Is ‘No Substitutes for Traded Goods’ a reason for Purchasing Power disparity?

Answer 9

Yes
- If substitute goods are not available domestically, consumers may not stop buying imported goods

Question 10

What is the Fisher Effect?

Answer 10

The Fisher Effect:
Suggests that the nominal interest rate contains two components:
- Expected inflation rate
- Real interest rate
The real rate of interest represents the return on the investment to savers after accounting for expected inflation

Question 11

What is the IFE? And can it be used to determine how exchange rates will change between two countries?

Answer 11

IFE = International Fisher Effect
Yes it can be used to determine how exchange rates will change between two countries
- The international Fisher effect (IFE) 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 PPP effect)
- The implications are similar for foreign investors who attempt to capitalise on relatively high Australian interest rates. The foreign investors will be adversely affected by the effects of a relatively high Australian inflation rate if they try to capitalise on the high Australian interest rates

Question 12

What are some issues with the Fisher Effect?

Answer 12

**Limitation of the Fisher Effect **
- 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
**Limitation of PPP **
- 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