C HA P T E R 8C HA P T E R 8

Relationships among Inflation, Relationships among Inflation, Interest Rates, and Exchange Interest Rates, and Exchange

RatesRates

Chapter OverviewChapter Overview

A. Purchasing Power Parity (PPP)A. Purchasing Power Parity (PPP)

B. International Fisher Effect (IFE)B. International Fisher Effect (IFE)

C. Comparison of the IRP, PPP, C. Comparison of the IRP, PPP, and and IFE TheoriesIFE Theories

Chapter 8 ObjectivesChapter 8 Objectives

This chapter will:This chapter will:A. Explain the purchasing power parity (PPP) A. Explain the purchasing power parity (PPP)

theory and its implications for exchange theory and its implications for exchange rate changesrate changes

B. Explain the International Fisher effect B. Explain the International Fisher effect (IFE) theory and its implications for (IFE) theory and its implications for exchange rate changesexchange rate changes

C. Compare the PPP theory, the IFE theory, C. Compare the PPP theory, the IFE theory, and the theory of interest rate parity and the theory of interest rate parity

(IRP), which was introduced in the (IRP), which was introduced in the previous chapterprevious chapter

A. Purchasing Power Parity (PPP)A. Purchasing Power Parity (PPP)

1. Interpretations of Purchasing Power 1. Interpretations of Purchasing Power ParityParity

a. Absolute Form of PPPa. Absolute Form of PPP

b. Relative Form of PPPb. Relative Form of PPP

2. Rationale behind Purchasing Power 2. Rationale behind Purchasing Power Parity TheoryParity Theory

3. Derivation of Purchasing Power 3. Derivation of Purchasing Power ParityParity

A. Purchasing Power Parity (PPP)A. Purchasing Power Parity (PPP)

4. Using PPP to Estimate Exchange 4. Using PPP to Estimate Exchange Rate Rate EffectsEffects

a. Using a Simplified PPP a. Using a Simplified PPP Relationship Relationship

5. Graphic Analysis of Purchasing 5. Graphic Analysis of Purchasing Power ParityPower Parity

a. PPP Linea. PPP Line

b. Purchasing Power Disparityb. Purchasing Power Disparity

8.18.1

Illustration of Purchasing Power Parity

A. Purchasing Power Parity (PPP)A. Purchasing Power Parity (PPP)

6. Testing the Purchasing Power Parity 6. Testing the Purchasing Power Parity TheoryTheorya. Conceptual Tests of PPPa. Conceptual Tests of PPP

1.) choose two countries (say, the United 1.) choose two countries (say, the United States and a foreign country) States and a foreign country)

2.) compare the2.) compare the differential in their differential in their inflation rates to the percentage inflation rates to the percentage change in the foreign currency’s change in the foreign currency’s value during several time periods. value during several time periods.

8.28.2

Identifying Disparity in Purchasing Power

A. Purchasing Power Parity (PPP)A. Purchasing Power Parity (PPP)

b. Statistical Test of PPPb. Statistical Test of PPP

c. Results of Tests of PPPc. Results of Tests of PPP

d. Tests of PPP for Each Currencyd. Tests of PPP for Each Currency

e. Limitations of PPP Testse. Limitations of PPP Tests

8.38.3

Comparison of Annual Inflation Differentials and Exchange Rate MovementsFor Four Major Currencies

A. Purchasing Power Parity (PPP)A. Purchasing Power Parity (PPP)

7. Why Purchasing Power Parity Does 7. Why Purchasing Power Parity Does Not OccurNot Occur

a. Confounding Effectsa. Confounding Effects

b. No Substitutes for Traded b. No Substitutes for Traded Goods Goods

A. Purchasing Power Parity (PPP)A. Purchasing Power Parity (PPP)

8. Purchasing Power Parity in the Long Run8. Purchasing Power Parity in the Long RunAbuaf and Jorion: a. suggest that deviations from PPP are substantial in the short run but are reduced by about half in 3 years. b. even though exchange rates deviate from the levels predicted by PPP in the short run, their deviations are re- duced over the long run.

B. International Fisher Effect (IFE)B. International Fisher Effect (IFE)

1. Relationship with Purchasing Power 1. Relationship with Purchasing Power ParityParity

2. Implications of the IFE for Foreign 2. Implications of the IFE for Foreign InvestorsInvestors

B. International Fisher Effect (IFE)B. International Fisher Effect (IFE)

3. Derivation of the International 3. Derivation of the International Fisher EffectFisher Effect

a. Numerical Example based on a. Numerical Example based on the Derivation of IFE the Derivation of IFE

b. Simplified Relationshipb. Simplified Relationship

B. International Fisher Effect (IFE)B. International Fisher Effect (IFE)

4. Graphic Analysis of the International 4. Graphic Analysis of the International Fisher EffectFisher Effect

a. Points on the IFE Linea. Points on the IFE Line

b. Points below the IFE Lineb. Points below the IFE Line

c. Points above the IFE Linec. Points above the IFE Line

8.58.5

Illustration of IFE Line (When Exchange Rate Changes Perfectly Offset InterestRates Differentials)

B. International Fisher Effect (IFE)B. International Fisher Effect (IFE)

5. Test of the International Fisher 5. Test of the International Fisher EffectEffect

a. Results from testing the IFEa. Results from testing the IFE

b. Statistical Test of the IFEb. Statistical Test of the IFE

B. International Fisher Effect (IFE)B. International Fisher Effect (IFE)

6. Why the international Fisher Effect 6. Why the international Fisher Effect Does Not OccurDoes Not Occur

a. PPP does not hold in certain a. PPP does not hold in certain timestimes

b. Since IFE based on PPP, it doesb. Since IFE based on PPP, it does

not hold consistently eithernot hold consistently either

C. Comparison of the IRP, PPP, C. Comparison of the IRP, PPP, and IFE Theoriesand IFE Theories

8.78.7