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Relationships among Inflation, Interest Rates, and Exchange Rates

PURCHASING POWER PARITY (PPP)


purchasing power parity (PPP) theory, which attempts to quantify the relationship
between inflation and the exchange rate.
There are two popular forms of PPP theory, each with its own implications :
 Absolute Form of PPP. The absolute form of PPP is based on the idea that, in the
absence of international barriers, consumers will shift their demand to wherever prices
are lowest. The existence of transportation costs, tariffs, and quotas render the absolute
form of PPP unrealistic.
 Relative Form of PPP. The relative form of PPP accounts for such market imperfections
as transportation costs, tariffs, and quotas. However, this form of PPP suggests that the
rate of change in the prices should be comparable when measured in a common
currency (assuming that transportation costs and trade barriers are unchanged).
Derivation of Purchasing Power Parity

This equality expresses the relationship (according to PPP) between relative inflation
rates and the exchange rate. Observe that if Ih > If then ef should be positive, which implies
that the foreign currency will appreciate when the home country’s inflation exceeds the foreign
country’s inflation. Conversely, 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
Why Purchasing Power Parity Does Not Hold
 Confounding Effects. The PPP theory presumes that exchange rate movements are
driven completely by the inflation differential between two countries.

 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 goods and instead purchase domestic goods. This shift, in turn, affects
the exchange rate. However, if substitute goods are not available domestically then
consumers will probably not desist from buying imported goods.
INTERNATIONAL FISHER EFFECT (IFE)
 It uses the difference in interest (rather than inflation) rates to explain why exchange
rates shift over time
 The first step in understanding the international Fisher effect is to recognize how a
country’s nominal (quoted) interest rate and inflation rate are related. This relation is
commonly referred to as the Fisher effect, named after the economist Irving Fisher. The
Fisher effect presumes that the nominal interest rate consists of two components: the
expected inflation rate and the real rate of interest. The real rate of interest is defined as
the return on the investment to savers after accounting for expected inflation, and it is
measured as the nominal interest rate minus the expected inflation rate. If the real rate
of interest in a country is constant over time, then the nominal rate of interest there must
adjust to changes in the expected rate of inflation.
Using the IFE to Predict Exchange Rate Movements
 Apply the Fisher Effect to Derive Expected Inflation per Country. The first step is
to derive the expected inflation rates of the two countries based on the Fisher effect’s
claim that the nominal interest rate in two countries differs because of the difference in
their expected inflation. By assuming that the real interest rate is the same in the two
countries, the difference between them in terms of the nominal interest rate is
completely attributed to the difference in their expected inflation rates. Thus the
difference in expected inflation is equal to the difference in nominal interest rates
between the two countries, which means that expected inflation is higher in the country
whose interest rate is higher.
 Rely on PPP to Estimate the Exchange Rate Movement. The second step when using
the international Fisher effect to predict movements in the exchange rate is to determine
via PPP how the exchange rate would change in response to the two countries’ expected
inflation rates as calculated in the first step. As discussed previously, the theory of
purchasing power parity argues that international trade flows adjust in response to
differential inflation rates; in particular, the country with the higher inflation increases
its demand for imports and experiences a reduced demand for its exports. This shift in
trade flows causes the currency with the higher inflation to depreciate, and the shift in
trade continues until a new equilibrium is reached in which the level of depreciation
offsets the inflation differential (i.e., the point at which a consumer’s purchasing power
is the same for products in either country).
COMPARISON OF THE IRP, PPP, AND IFE

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