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# Relationship Between Inflation, Interest Rates, and Exchange Rates

Purchasing Power Parity (PPP) is the notion that the ratio between domestic and foreign price levels should equal the equilibrium exchange rate between domestic and foreign currencies. PPP theory takes two basic forms: The absolute form, also called the law of one price, suggests that prices of similar products of two different countries should be equal when measured in a common currency. The relative form of PPP is an alternative version that accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas.

## Derivation of Purchasing Power Parity

(1 I ) h 1 (1 I ) f

## A more simplified but less precise relationship based on PPP is

e f Ih If
That is, the exchange rate percentage change should be approximately equal to the differential in inflation rates between two countries.

## Using PPP to Forecast

St+1 = S (1+ef ) St+1 = S[1+ (Ih If)]

## Derivation of Purchasing Power Parity

Assume that the exchange rate is in equilibrium initially. Then the home currency experiences a 5 % exchange rate, while the foreign country experiences a 3 % inflation rate. According to PPP, the foreign currency will adjust as shown: ef = 1+.05/1+ .03 1 = .0194, or 1.94% Assume that the exchange rate is in equilibrium initially.Then the home country experiences a 4% inflation rate, while the foreign country experiences a 7% inflation rate. ef = 1+.04/1+ .07 1 = -.028, or 2.8%.

10
Ih-If(%)

## International Fisher Effect (IFE) Theory

IFE theory implies that exchange rates move to offset the interest rate differentials. The fisher effect states that the nominal interest rate (r) is made up of two components: (1) A real required rate of return, and (2) Anticipated inflation Assume that investors in the US expect a 6 percent rate of inflation over one year, and require a real return of 2 percent over one year, the nominal interest rate on oneyear treasury would be 8 percent.

## International Fisher Effect

(1 i ) h 1 (1 i ) f

## Derivation of International Fisher Effect

The formula for the actual or so called effective (exchange rate adjusted) return on a foreign bank deposit (or any market security) is r = (1+if)(1+ef) 1 According to the IFE, the effective return on a home investment should on average be equal to the effective return on a foreign investment. That is r = ih Accordingly, (1+if)(1+ef) 1 = ih Now solve for ef: (1+if)(1+ef) = (1+ih)
(1 ih) (1 if ) (1 ih) ef 1 (1 if ) (1 e f )

## A more simplified but less precise rule of the IFE is

ef ih if
That is, the exchange rate percentage change should be approximately equal to the interest rate differential between two countries.

## Using IFE to Forecast

St+1 = S (1+ef ) St+1 = S[1+ (ih if)]

## Practical Problem on IFE

Assume that the interest rate on on a one-year insured home bank deposit is 11 percent and the interest rate on a oneyear insured foreign bank deposit is 12 percent. For the actual returns of these two investments to be similar from the perspective of investors in the home country, calculate the percentage change in the value of the foreign currency (ef) dominating the security.
ef (1 ih ) 1 (1 i f ) (1 .11) 1 (1 .12) .0089, or .89%

Theory

## Key Variables of Theory

Interest rate differential Inflation rate differential

Interest rate parity Forward rate Premium (or discount) Purchasing power % change in parity (PPP) spot exchange rate International % change in Fisher Effect (IFE) spot exchange rate

## Interest rate differential

Practical Problems
1. Assume that the Canadian dollars spot rate is \$.85 and that the Canadian US inflation rates are similar. Then assume that the Canadian experiences 4 % inflation, while the US experiences 3 % inflation . According to PPP, what will be the new value of the C\$ after it adjusts to the inflationary changes? Australian dollars spot rate is \$.90 and that Australian and US one year interest rates were initially 6 %. Then assume that the Australian one-year interest rate increases by 5 percentage points, while the US one-year interest rate remains unchanged. Using this information and the IFE theory, forecast spot rate for one-year ahead.

2.