Chapter 8

Relationships Among Inflation,
Interest Rates, and Exchange Rates
Lecture Outline
Purchasing Power Parity (PPP)
Interpretations of PPP
Rationale Behind PPP Theory
Derivation of PPP
Using PPP to Estimate Exchange Rate Effects
Graphic Analysis of PPP
Testing the PPP Theory
Why PPP Does ot !cc"r
PPP in the #ong R"n
International isher Effect (IE)
Implications of the I$E for $oreign Investors
Derivation of the I$E
Graphic Analysis of the I$E
Tests of the I$E
Why the I$E Does ot !cc"r
Comparison of IRP, PPP, and IE !heories
%&'
%&( International Financial Management
Chapter Theme
This chapter disc"sses the relationship )et*een inflation and exchange rates according to the p"rchasing
po*er parity +PPP, theory- .ince this is one of the most pop"lar s")/ects in international finance0 it is
covered thoro"ghly- While PPP is a relevant theory0 it sho"ld )e emphasi1ed that PPP *ill not al*ays
hold in reality- It does ho*ever0 provide a fo"ndation in "nderstanding ho* inflation can affect
exchange rates- The international $isher effect +I$E, is also disc"ssed in this chapter- This theory is
also very important- 2et0 it sho"ld again )e emphasi1ed that this theory does not al*ays hold- If the
PPP and I$E theories held consistently0 decision ma3ing )y 45s *o"ld )e m"ch easier- Beca"se
these theories do not hold consistently0 an 456s decision ma3ing is very challenging-
Topics to Stimulate Class Discussion
%- Provide reasoning for *hy highly inflated co"ntries s"ch as Bra1il tend to have *ea3 home
c"rrencies-
7- Identify the inflation rate of yo"r home co"ntry and some *ell83no*n foreign co"ntry- Then
identify the percentage change of yo"r home c"rrency *ith respect to that foreign co"ntry- Did the
c"rrency change in the direction and )y the magnit"de that yo" *o"ld have expected according to
PPP9 If not0 offer possi)le reasons for this discrepancy-
:- Identify the ;"oted one8year interest rates in yo"r home co"ntry and in a *ell83no*n foreign
co"ntry as of one year ago- Also determine ho* yo"r home c"rrency changed relative to this
foreign c"rrency over the last year- Did the c"rrency change according to the I$E theory9 If not0
does this information disprove I$E9 Ela)orate-
<- Provide a simple explanation of the difference )et*een interest rate parity +from the previo"s
chapter,0 PPP +from this chapter,0 and I$E +from this chapter,-
P"I#!$C"%#!ER&P"I#!'
(oes PPP Eliminate Concerns a)out *ong&!erm Exchange Rate Ris+,
P!IT' 2es- .t"dies have sho*n that exchange rate movements are related to inflation differentials in
the long r"n- Based on PPP0 the c"rrency of a high8inflation co"ntry *ill depreciate against the dollar- A
s")sidiary in that co"ntry sho"ld generate inflated reven"e from the inflation0 *hich *ill help offset the
adverse exchange effects *hen its earnings are remitted to the parent- If a firm is foc"sed on long8term
performance0 the deviations from PPP *ill offset over time- In some years0 the exchange rate effects
may exceed the inflation effects0 and in other years the inflation effects *ill exceed the exchange rate
effects-
5!UTER8P!IT= o- Even if the relationship )et*een inflation and exchange rate effects is
consistent0 this does not g"arantee that the effects on the firm *ill )e offsetting- A s")sidiary in a high8
inflation co"ntry *ill not necessarily )e a)le to ad/"st its price level to 3eep "p *ith the increased costs
of doing )"siness there- The effects vary *ith each 456s sit"ation- Even if the s")sidiary can raise its
prices to match the rising costs0 there are short8term deviations from PPP- The investors *ho invest in
an 456s stoc3 may )e concerned a)o"t short8term deviations from PPP0 )eca"se they *ill not
necessarily hold the stoc3 for the long term- Th"s0 investors may prefer that firms manage in a manner
that red"ces the volatility in their performance in short8r"n and long8r"n periods-
Chapter 8: Relationships Among Inflation, Interest Rates, and Exchange Rates %&>
W?! I. 5!RRE5T9 Use InfoTrac or some other search engine to learn more a)o"t this iss"e- Which
arg"ment do yo" s"pport9 !ffer yo"r o*n opinion on this iss"e-
A.WER= It is possi)le that inflation and exchange rate effects *ill offset over the long r"n- ?o*ever0
many investors *ill not )e satisfied )eca"se they may invest in the firm for /"st a fe* years or even a
shorter term- Th"s0 they *ill prefer that 45s assess their expos"re to exchange rate ris3 and attempt
to limit the ris3-
Answers to End of Chapter Questions
-. PPP. Explain the theory of p"rchasing po*er parity +PPP,- Based on this theory0 *hat is a general
forecast of the val"es of c"rrencies in co"ntries *ith high inflation9
A.WER= PPP s"ggests that the p"rchasing po*er of a cons"mer *ill )e similar *hen p"rchasing
goods in a foreign co"ntry or in the home co"ntry- If inflation in a foreign co"ntry differs from
inflation in the home co"ntry0 the exchange rate *ill ad/"st to maintain e;"al p"rchasing po*er-
5"rrencies in co"ntries *ith high inflation *ill )e *ea3 according to PPP0 ca"sing the p"rchasing
po*er of goods in the home co"ntry vers"s these co"ntries to )e similar-
/. Rationale of PPP. Explain the rationale of the PPP theory-
A.WER= When inflation is high in a partic"lar co"ntry0 foreign demand for goods in that co"ntry
*ill decrease- In addition0 that co"ntry6s demand for foreign goods sho"ld increase- Th"s0 the
home c"rrency of that co"ntry *ill *ea3en@ this tendency sho"ld contin"e "ntil the c"rrency has
*ea3ened to the extent that a foreign co"ntry6s goods are no more attractive than the home
co"ntry6s goods- Inflation differentials are offset )y exchange rate changes-
0. !esting PPP. Explain ho* yo" co"ld determine *hether PPP exists- Descri)e a limitation in testing
*hether PPP holds-
A.WER= !ne method is to choose t*o co"ntries and compare the inflation differential to the
exchange rate change for several different periods- Then0 determine *hether the exchange rate
changes *ere similar to *hat *o"ld have )een expected "nder PPP theory-
A second method is to choose a variety of co"ntries and compare the inflation differential of each
foreign co"ntry relative to the home co"ntry for a given period- Then0 determine *hether the
exchange rate changes of each foreign c"rrency *ere *hat *o"ld have )een expected )ased on the
inflation differentials "nder PPP theory-
A limitation in testing PPP is that the res"lts *ill vary *ith the )ase period chosen- The )ase period
sho"ld reflect an e;"ili)ri"m position0 )"t it is diffic"lt to determine *hen s"ch a period exists-
%&A International Financial Management
1. !esting PPP. Inflation differentials )et*een the U-.- and other ind"striali1ed co"ntries have
typically )een a fe* percentage points in any given year- 2et0 in many years ann"al exchange rates
)et*een the corresponding c"rrencies have changed )y %& percent or more- What does this
information s"ggest a)o"t PPP9
A.WER= The information s"ggests that there are other factors )esides inflation differentials that
infl"ence exchange rate movements- Th"s0 the exchange rate movements *ill not necessarily
conform to inflation differentials0 and therefore PPP *ill not necessarily hold-
2. *imitations of PPP. Explain *hy PPP does not hold-
A.WER= PPP does not consistently hold )eca"se there are other factors )esides inflation that
infl"ences exchange rates- Th"s0 exchange rates *ill not move in perfect tandem *ith inflation
differentials- In addition0 there may not )e s")stit"tes for traded goods- Therefore0 even *hen a
co"ntry6s inflation increases0 the foreign demand for its prod"cts *ill not necessarily decrease +in
the manner s"ggested )y PPP, if s")stit"tes are not availa)le-
3. Implications of IE. Explain the international $isher effect +I$E,- What is the rationale for the
existence of the I$E9 What are the implications of the I$E for firms *ith excess cash that consis8
tently invest in foreign Treas"ry )ills9 Explain *hy the I$E may not hold-
A.WER= The I$E s"ggests that a c"rrency6s val"e *ill ad/"st in accordance *ith the differential
in interest rates )et*een t*o co"ntries-
The rationale is that if a partic"lar c"rrency exhi)its a high nominal interest rate0 this may reflect a
high anticipated inflation- Th"s0 the inflation *ill place do*n*ard press"re on the c"rrency6s val"e
if it occ"rs-
The implications are that a firm that consistently p"rchases foreign Treas"ry )ills *ill on average
earn a similar ret"rn as on domestic Treas"ry )ills-
The I$E may not hold )eca"se exchange rate movements react to other factors in addition to interest
rate differentials- Therefore0 an exchange rate *ill not necessarily ad/"st in accordance *ith the
nominal interest rate differentials0 so that I$E may not hold-
4. Implications of IE. Ass"me U-.- interest rates are generally a)ove foreign interest rates- What
does this s"ggest a)o"t the f"t"re strength or *ea3ness of the dollar )ased on the I$E9 .ho"ld U-.-
investors invest in foreign sec"rities if they )elieve in the I$E9 .ho"ld foreign investors invest in
U-.- sec"rities if they )elieve in the I$E9
A.WER= The I$E *o"ld s"ggest that the U-.- dollar *ill depreciate over time if U-.- interest
rates are c"rrently higher than foreign interest rates- 5onse;"ently0 foreign investors *ho
p"rchased U-.- sec"rities *o"ld on average receive a similar yield as *hat they receive in their o*n
co"ntry0 and U-.- investors that p"rchased foreign sec"rities *o"ld on average receive a yield
similar to U-.- rates-
Chapter 8: Relationships Among Inflation, Interest Rates, and Exchange Rates %&B
8. Comparing Parity !heories. 5ompare and contrast interest rate parity +disc"ssed in the previo"s
chapter,0 p"rchasing po*er parity +PPP,0 and the international $isher effect +I$E,-
A.WER= Interest rate parity can )e eval"ated "sing data at any one point in time to determine the
relationship )et*een the interest rate differential of t*o co"ntries and the for*ard premi"m +or
disco"nt,- PPP s"ggests a relationship )et*een the inflation differential of t*o co"ntries and the
percentage change in the spot exchange rate over time- I$E s"ggests a relationship )et*een the
interest rate differential of t*o co"ntries and the percentage change in the spot exchange rate over
time- I$E is )ased on nominal interest rate differentials0 *hich are infl"enced )y expected
inflation- Th"s0 the I$E is closely related to PPP-
5. Real Interest Rate. !ne ass"mption made in developing the I$E is that all investors in all co"ntries
have the same real interest rate- What does this mean9
A.WER= The real ret"rn is the nominal ret"rn min"s the inflation rate- If all investors re;"ire
the same real ret"rn0 then the differentials in nominal interest rates sho"ld )e solely d"e to
differentials in anticipated inflation among co"ntries-
-6. Interpreting Inflationary Expectations. If investors in the United .tates and 5anada re;"ire the
same real interest rate0 and the nominal rate of interest is 7 percent higher in 5anada0 *hat does this
imply a)o"t expectations of U-.- inflation and 5anadian inflation9 What do these inflationary
expectations s"ggest a)o"t f"t"re exchange rates9
A.WER= Expected inflation in 5anada is 7 percent a)ove expected inflation in the U-.- If these
inflationary expectations come tr"e0 PPP *o"ld s"ggest that the val"e of the 5anadian dollar sho"ld
depreciate )y 7 percent against the U-.- dollar-
--. PPP Applied to the Euro. Ass"me that several E"ropean co"ntries that "se the e"ro as their
c"rrency experience higher inflation than the United .tates0 *hile t*o other E"ropean co"ntries that
"se the e"ro as their c"rrency experience lo*er inflation than the United .tates- According to PPP0
ho* *ill the e"ro6s val"e against the dollar )e affected9
A.WER= The high E"ropean inflation overall *o"ld red"ce the U-.- demand for E"ropean
prod"cts0 increase the E"ropean demand for U-.- prod"cts0 and ca"se the e"ro to depreciate against
the dollar-
According to the PPP theory0 the e"roCs val"e *o"ld ad/"st in response to the *eighted inflation
rates of the E"ropean co"ntries that are represented )y the e"ro relative to the inflation in the U-.-
If the E"ropean inflation rises0 *hile the U-.- inflation remains lo*0 there *o"ld )e do*n*ard
press"re on the e"ro-
-/. 7ource of 8ea+ Currencies. 5"rrencies of some #atin American co"ntries0 s"ch as Bra1il and
Dene1"ela0 fre;"ently *ea3en against most other c"rrencies- What concept in this chapter explains
this occ"rrence9 Why don6t all U-.-8)ased 45s "se for*ard contracts to hedge their f"t"re
remittances of f"nds from #atin American co"ntries to the U-.- even if they expect depreciation of
the c"rrencies against the dollar9
A.WER= #atin American co"ntries typically have very high inflation0 as m"ch as 7&& percent or
more- PPP theory *o"ld s"ggest that c"rrencies of these co"ntries *ill depreciate against the U-.-
dollar +and other ma/or c"rrencies, in order to retain p"rchasing po*er across co"ntries- The high
inflation disco"rages demand for #atin American imports and places do*n*ard press"re in their
%%& International Financial Management
#atin American c"rrencies- Depreciation of the c"rrencies offsets the increased prices on #atin
American goods from the perspective of importers in other co"ntries-
Interest rate parity forces the for*ard rates to contain a large disco"nt d"e to the high interest rates
in #atin America0 *hich reflects a disadvantage of hedging these c"rrencies- The decision to hedge
ma3es more sense if the expected degree of depreciation exceeds the degree of the for*ard disco"nt-
Also0 3eep in mind that some remittances cannot )e perfectly hedged any*ay )eca"se the amo"nt of
f"t"re remittances is "ncertain-
-0. PPP. Eapan has typically had lo*er inflation than the United .tates- ?o* *o"ld one expect this to
affect the Eapanese yen6s val"e9 Why does this expected relationship not al*ays occ"r9
A.WER= Eapan6s lo* inflation sho"ld place "p*ard press"re on the yen6s val"e- 2et0 other
factors can sometimes offset this press"re- $or example0 Eapan heavily invests in U-.- sec"rities0
*hich places do*n*ard press"re on the yen6s val"e-
-1. IE. Ass"me that the nominal interest rate in 4exico is <A percent and the interest rate in the
United .tates is A percent for one8year sec"rities that are free from defa"lt ris3- What does the I$E
s"ggest a)o"t the differential in expected inflation in these t*o co"ntries9 Using this information
and the PPP theory0 descri)e the expected nominal ret"rn to U-.- investors *ho invest in 4exico-
A.WER= If investors from the U-.- and 4exico re;"ired the same real +inflation8ad/"sted,
ret"rn0 then any difference in nominal interest rates is d"e to differences in expected inflation-
Th"s0 the inflation rate in 4exico is expected to )e a)o"t <& percent a)ove the U-.- inflation rate-
According to PPP0 the 4exican peso sho"ld depreciate )y the amo"nt of the differential )et*een
U-.- and 4exican inflation rates- Using a <& percent differential0 the 4exican peso sho"ld
depreciate )y a)o"t <& percent- Given a <A percent nominal interest rate in 4exico and expected
depreciation of the peso of <& percent0 U-.- investors *ill earn a)o"t A percent- +This ans*er "sed
the inexact form"la0 since the concept is stressed here more than precision-,
-2. IE. .ho"ldn6t the I$E disco"rage investors from attempting to capitali1e on higher foreign interest
rates9 Why do some investors contin"e to invest overseas0 even *hen they have no other
transactions overseas9
A.WER= According to the I$E0 higher foreign interest rates sho"ld not attract investors )eca"se
these rates imply high expected inflation rates0 *hich in t"rn imply potential depreciation of these
c"rrencies- 2et0 some investors still invest in foreign co"ntries *here nominal interest rates are
high- This may s"ggest that some investors )elieve that +%, the anticipated inflation rate em)edded
in a high nominal interest rate is overestimated0 or +7, the potentially high inflation *ill not ca"se
s")stantial depreciation of the foreign c"rrency +*hich co"ld occ"r if ade;"ate s")stit"te prod"cts
*ere not availa)le else*here,0 or +:, there are other factors that can offset the possi)le impact of
inflation on the foreign c"rrency6s val"e-
Chapter 8: Relationships Among Inflation, Interest Rates, and Exchange Rates %%%
-3. Changes in Inflation. Ass"me that the inflation rate in Bra1il is expected to increase s")stantially-
?o* *ill this affect Bra1il6s nominal interest rates and the val"e of its c"rrency +called the real,9 If
the I$E holds0 ho* *ill the nominal ret"rn to U-.- investors *ho invest in Bra1il )e affected )y the
higher inflation in Bra1il9 Explain-
A.WER= Bra1il6s nominal interest rate *o"ld li3ely increase to maintain the real ret"rn re;"ired
)y Bra1ilian investors- The Bra1ilian real *o"ld )e expected to depreciate according to the I$E- If
the I$E holds0 the ret"rn to U-.- investors *ho invest in Bra1il *o"ld not )e affected- Even tho"gh
they no* earn a higher nominal interest rate0 the expected decline in the Bra1ilian real offsets the
additional interest to )e earned-
-4. Comparing PPP and IE. ?o* is it possi)le for PPP to hold if the I$E does not9
A.WER= $or the I$E to hold0 the follo*ing conditions are necessary=
+%, investors across co"ntries re;"ire the same real ret"rns0
+7, the expected inflation rate em)edded in the nominal interest rate occ"rs0
+:, the exchange rate ad/"sts to the inflation rate differential according to PPP-
If conditions +%, or +7, do not hold0 PPP may still hold0 )"t investors may achieve consistently
higher ret"rns *hen investing in a foreign co"ntry6s sec"rities- Th"s0 I$E *o"ld )e ref"ted-
-8. Estimating (epreciation (ue to PPP. Ass"me that the spot exchange rate of the British po"nd is
F%->:- ?o* *ill this spot rate ad/"st according to PPP if the United Gingdom experiences an
inflation rate of > percent *hile the United .tates experiences an inflation rate of 7 percent9
A.WER= According to PPP0 the exchange rate of the po"nd *ill depreciate )y <-> percent-
Therefore0 the spot rate *o"ld ad/"st to F%->: H I% J +K-&<>,L M F%-('-
-5. orecasting the uture 7pot Rate 9ased on IE. Ass"me that the spot exchange rate of the
.ingapore dollar is F->&- The one8year interest rate is %% percent in the United .tates and > percent
in .ingapore- What *ill the spot rate )e in one year according to the I$E9 +2o" may "se the
approximate form"la to ans*er this ;"estion-,
A.WER= F->& H +% J -&<, M F->7A
/6. (eri:ing orecasts of the uture 7pot Rate. As of today0 ass"me the follo*ing information is
availa)le=
U-.- 4exico
Real rate of interest re;"ired
)y investors 7N 7N
ominal interest rate %%N %'N
.pot rate O F-7&
!ne8year for*ard rate O F-%B
%%7 International Financial Management
a- Use the for*ard rate to forecast the percentage change in the 4exican peso over the next year-
A.WER= +F-%B K F-7&,PF-7& M K-&'0 or K'N
)- Use the differential in expected inflation to forecast the percentage change in the 4exican peso
over the next year-
A.WER= %%N K %'N M K<N@ the negative sign represents depreciation of the peso-
c- Use the spot rate to forecast the percentage change in the 4exican peso over the next year-
A.WER= 1ero percent change
/-. Inflation and Interest Rate Effects. The opening of R"ssiaCs mar3et has res"lted in a highly
volatile R"ssian c"rrency +the r")le,- R"ssiaCs inflation has commonly exceeded 7& percent per
month- R"ssian interest rates commonly exceed %'& percent0 )"t this is sometimes less than the
ann"al inflation rate in R"ssia-
a- Explain *hy the high R"ssian inflation has p"t severe press"re on the val"e of the R"ssian
r")le-
A.WER= As R"ssian prices *ere increasing0 the p"rchasing po*er of R"ssian cons"mers
*as declining- This *o"ld enco"rage them to p"rchase goods in the U-.- and else*here0 *hich
res"lts in a large s"pply of r")les for sale- Given the high R"ssian inflation0 foreign demand
for r")les to p"rchase R"ssian goods *o"ld )e lo*- Th"s0 the r")le6s val"e sho"ld depreciate
against the dollar0 and against other c"rrencies-
)- Does the effect of R"ssian inflation on the decline in the r")le6s val"e s"pport the PPP theory9
?o* might the relationship )e distorted )y political conditions in R"ssia9
A.WER= The general relationship s"ggested )y PPP is s"pported0 )"t the r")le6s val"e *ill
not normally move exactly as specified )y PPP- The political conditions that co"ld restrict
trade or c"rrency converti)ility can prevent R"ssian cons"mers from shifting to foreign goods-
Th"s0 the r")le may not decline )y the f"ll degree to offset the inflation differential )et*een
R"ssia and the U-.- $"rthermore0 the government may not allo* the r")le to float freely to its
proper e;"ili)ri"m level-
c- Does it appear that the prices of R"ssian goods *ill )e e;"al to the prices of U-.- goods from
the perspective of R"ssian cons"mers +after considering exchange rates,9 Explain-
A.WER= R"ssian prices might )e higher than U-.- prices0 even after considering exchange
rates0 )eca"se the r")le might not depreciate eno"gh to f"lly offset the R"ssian inflation- The
exchange rate cannot f"lly ad/"st if there are )arriers on trade or c"rrency converti)ility-
d- Will the effects of the high R"ssian inflation and the decline in the r")le offset each other for
U-.- importers9 That is0 ho* *ill U-.- importers of R"ssian goods )e affected )y the
conditions9
A.WER= U-.- importers *ill li3ely experience higher prices0 )eca"se the R"ssian inflation may
not )e completely offset )y the decline in the r")le6s val"e- This may ca"se a red"ction in the U-.-
demand for R"ssian goods-
Chapter 8: Relationships Among Inflation, Interest Rates, and Exchange Rates %%:
//. IE Application to Asian Crisis. Before the Asian crisis0 many investors attempted to capitali1e on
the high interest rates prevailing in the .o"theast Asian co"ntries altho"gh the level of interest rates
primarily reflected expectations of inflation- Explain *hy investors )ehaved in this manner-
Why does the I$E s"ggest that the .o"theast Asian co"ntries *o"ld not have attracted foreign
investment )efore the Asian crisis despite the high interest rates prevailing in those co"ntries9
A.WER= The investorsC )ehavior s"ggests that they did not expect the international $isher effect
+I$E, to hold- .ince central )an3s of some Asian co"ntries *ere maintaining their c"rrencies *ithin
narro* )ands0 they *ere effectively preventing the exchange rate from depreciating in a manner that
*o"ld offset the interest rate differential- 5onse;"ently0 s"perior profits from investing in the
foreign co"ntries *ere possi)le-
If investors )elieved in the I$E0 the Asian co"ntries *o"ld not attract a high level of foreign
investment )eca"se of exchange rate expectations- .pecifically0 the high nominal interest rate
sho"ld reflect a high level of expected inflation- According to p"rchasing po*er parity +PPP,0 the
higher interest rate sho"ld res"lt in a *ea3er c"rrency )eca"se of the implied mar3et expectations of
high inflation-
/0. IE Applied to the Euro. Given the recent conversion of several E"ropean c"rrencies to the e"ro0
explain *hat *o"ld ca"se the e"ro6s val"e to change against the dollar according to the I$E-
A.WER= If interest rates change in these E"ropean co"ntries *hose home c"rrency is the e"ro0
the expected inflation rate in those co"ntries change0 so that the inflation differential )et*een those
co"ntries and the U-.- changes- Th"s0 there may )e an impact on the val"e of the e"ro0 )eca"se a
change in the inflation differential affects trade flo*s and therefore affects the exchange rate-
Advanced Questions
/1. IE. Beth 4iller does not )elieve that the international $isher effect +I$E, holds- 5"rrent one8year
interest rates in E"rope are ' percent0 *hile one8year interest rates in the U-.- are : percent- Beth
converts F%&&0&&& to e"ros and invests them in Germany- !ne year later0 she converts the e"ros
)ac3 to dollars- The c"rrent spot rate of the e"ro is F%-%&-
a- According to the I$E0 *hat sho"ld the spot rate of the e"ro in one year )e9
)- If the spot rate of the e"ro in one year is F%-&&0 *hat is Beth6s percentage ret"rn from her
strategy9
c- If the spot rate of the e"ro in one year is F%-&A0 *hat is Beth6s percentage ret"rn from her
strategy9
d- What m"st the spot rate of the e"ro )e in one year for Beth6s strategy to )e s"ccessf"l9
%%< International Financial Management
A.WER=
a-
N B& - % %
, &' - % +
, &: - % +
%
, % +
, % +
− · − ·

+
+
·
f
h
f
i
i
e
If the I$E holds0 the e"ro sho"ld depreciate )y %-B& percent in one year- This translates to a spot
rate of F%-%& H +% K %-B&N, M F%-&>B-
)-
%- 5onvert dollars to e"ros= F%&&0&&&PF%-%& M QB&0B&B-&B
7- Invest e"ros for one year and receive QB&0B&B-&B H %-&' M QB'0<'<-''
:- 5onvert e"ros )ac3 to dollars and receive QB'0<'<-'' H F%-&& M FB'0<'<-''
The percentage ret"rn is FB'0<'<-''PF%&&0&&& K % M K<-''N-
c-
%- 5onvert dollars to e"ros= F%&&0&&&PF%-%& M QB&0B&B-&B
7- Invest e"ros for one year and receive QB&0B&B-&B H %-&' M QB'0<'<-''
:- 5onvert e"ros )ac3 to dollars and receive QB'0<'<-'' H F%-&A M F%&:0&B&-B%
The percentage ret"rn is F%&:0&B&-B%PF%&&0&&& K % M :-&BN-
d- Beth6s strategy *o"ld )e s"ccessf"l if the spot rate of the e"ro in one year is greater than
F%-&>B-
/2. Integrating IRP and IE. Ass"me the follo*ing information is availa)le for the U-.- and E"rope=
%.7. Europe
ominal interest rate <N (N
Expected inflation 7N 'N
.pot rate 88888 F%-%:
!ne8year for*ard rate 88888 F%-%&
a- Does IRP hold9
)- According to PPP0 *hat is the expected spot rate of the e"ro in one year9
c- According to the I$E0 *hat is the expected spot rate of the e"ro in one year9
d- Reconcile yo"r ans*ers to parts +a,- and +c,-
Chapter 8: Relationships Among Inflation, Interest Rates, and Exchange Rates %%'
A.WER=
a-
N AB - %
%
, &( - % +
, &< - % +
%
, % +
, % +
− ·
− ·

+
+
·
f
h
i
i
p
Therefore0 the for*ard rate of the e"ro sho"ld )e F%-%: H +% K %-ABN, M F%-%&B- IRP does not hold in
this case-
)-
N A( - 7
%
, &' - % +
, &7 - % +
%
, % +
, % +
− ·
− ·

+
+
·
f
h
f
I
I
e
According to PPP0 the expected spot rate of the e"ro in one year is F%-%: H +% K 7-A(N, M F%-&BA-
c-
N AB - %
%
, &( - % +
, &< - % +
%
, % +
, % +
− ·
− ·

+
+
·
f
h
f
i
i
e
According to the I$E0 the expected spot rate of the e"ro in one year is F%-%: H +% K 7-A(N, M F%-&BA-
Parts a and c com)ined say that the for*ard rate premi"m or disco"nt is exactly e;"al to the expected
percentage appreciation or depreciation of the e"ro-
/3. IRP. The one8year ris38free interest rate in 4exico is %&N- The one8year ris38free rate in the U-.- is
7N- Ass"me that interest rate parity exists- The spot rate of the 4exican peso is F-%<-
a- What is the for*ard rate premi"m9
)- What is the one8year for*ard rate of the peso9
c- Based on the international $isher effect0 *hat is the expected change in the spot rate over the next
year9
d- If the spot rate changes as expected according to the I$E0 *hat *ill )e the spot rate in one year9
e- 5ompare yo"r ans*ers to +), and +d, and explain the relationship-
%%( International Financial Management
A.WER=
a- According to interest rate parity0 the for*ard premi"m is
&>7>: - %
, %& - % +
, &7 - % +
− · −
+
+
)- The for*ard rate is F-%< H +% K -&>7>:, M F-%7BA-
c- According to the I$E0 the expected change in the peso is=
&>7>: - %
, %& - % +
, &7 - % +
− · −
+
+
or K>-7>:N
d- F-%< H +% K -&>7>:, M F-%7BA
e- The ans*ers are the same- When IRP holds0 the for*ard rate premi"m and the expected percentage
change in the spot rate are derived in the same manner- Th"s0 the for*ard premi"m serves as the
forecasted percentage change in the spot rate according to I$E-
/4. !esting the PPP. ?o* co"ld yo" "se regression analysis to determine *hether the relationship
specified )y PPP exists on average9 .pecify the model0 and descri)e ho* yo" *o"ld assess the
regression res"lts to determine if there is a significant difference from the relationship s"ggested )y
PPP-
A.WER= A regression model co"ld )e applied to historical data to test PPP- The model is
specified as=
( )
e a a
%J I
% J I
"
f & %
U-.-
f
· + −

¸

1
]
1 + %
*here ef is the percentage change in the foreign c"rrency6s exchange rate0 IU-.- and If are U-.- and
foreign inflation rates0 a& is a constant0 a% is the slope coefficient0 and " is an error term- If PPP
holds0 a& sho"ld e;"al 1ero0 and a% sho"ld e;"al %- A t8test on a& and a% is sho*n )elo*-
t 8 test for a = t M
a &
s-e- of a
t 8 test for a = t M
a %
s-e- of a
&
&
&
%
%
%


The t8statistic can )e compared to the critical level +from a t8ta)le, to determine *hether the val"es
of a& and a% differ significantly from their hypothesi1ed val"es-
Chapter 8: Relationships Among Inflation, Interest Rates, and Exchange Rates %%>
/8. !esting the IE. Descri)e a statistical test for the I$E-
A.WER= A regression model co"ld )e applied to historical data to test I$E- The model is
specified as=
( )
" J %
I J %
I J %
a J a M e
f
U-.-
% & f 1
]
1

¸


*here ef is the percentage change in the foreign c"rrency6s exchange rate0 IU-.- and If are U-.- and
foreign interest rates0 a& is a constant0 a% is the slope coefficient0 and " is an error term- If I$E
holds0 a& sho"ld e;"al 1ero and a% sho"ld e;"al %- A t8test on a& and a% is sho*n )elo*=
%
%
%
&
&
&
a of s-e-
% a
M t = a for test 8 t
a of s-e-
& a
M t = a for test 8 t


The t8statistic can )e compared to the critical level +from a t8ta)le, to determine *hether the val"es
of a& and a% differ significantly from their hypothesi1ed val"es-
/5. Impact of 9arriers on PPP and IE. Wo"ld PPP )e more li3ely to hold )et*een the United .tates
and ?"ngary if trade )arriers *ere completely removed and if ?"ngary6s c"rrency *ere allo*ed to
float *itho"t any government intervention9 Wo"ld the I$E )e more li3ely to hold )et*een the
United .tates and ?"ngary if trade )arriers *ere completely removed and if ?"ngary6s c"rrency
*ere allo*ed to float *itho"t any government intervention9 Explain-
A.WER= 5hanges in international trade res"lt from inflation differences and affects the exchange
rate +)y affecting the demand for the c"rrency and the s"pply of the c"rrency for sale,- The effect
on the exchange rate is more li3ely to occ"r if +a, free trade is allo*ed and +), the c"rrency6s
exchange rate is allo*ed to fl"ct"ate *itho"t any government intervention-
The "nderlying force of I$E is the differential in expected inflation )et*een t*o co"ntries0 *hich
can affect trade and capital flo*s- The effects on the exchange rate are more li3ely to occ"r if +a,
free trade is allo*ed0 and +), the c"rrency6s exchange rate is allo*ed to fl"ct"ate *itho"t
government intervention-
06. Interacti:e Effects of PPP. Ass"me that the inflation rates of the co"ntries that "se the e"ro are
very lo*0 *hile other E"ropean co"ntries that have their o*n c"rrencies experience high inflation-
Explain ho* and *hy the e"ro6s val"e co"ld )e expected to change against these c"rrencies
according to the PPP theory-
A.WER= According to the PPP theory0 the e"ro6s val"e *o"ld increase against the val"e of the
other E"ropean c"rrencies0 )eca"se the trade patterns *o"ld shift in response to the inflation
differential- There *o"ld )e an increase in demand for the e"ro )y these other E"ropean co"ntries
that experienced higher inflation )eca"se they *ill increase their importing of prod"cts from those
E"ropean co"ntries *hose home c"rrency is the e"ro-
%%A International Financial Management
0-. Applying IRP and IE. Ass"me that 4exico has a one8year interest rate that is higher than the
U-.- one8year interest rate- Ass"me that yo" )elieve in the international $isher effect +I$E,0 and
interest rate parity- Ass"me 1ero transactions costs-
Ed is )ased in the U-.- and he attempts to spec"late )y p"rchasing 4exican pesos today0 investing
the pesos in a ris38free asset for a year0 and then converting the pesos to dollars at the end of one
year- Ed did not cover his position in the for*ard mar3et-
4aria is )ased in 4exico and she attempts covered interest ar)itrage )y p"rchasing dollars today
and sim"ltaneo"sly selling dollars one year for*ard0 investing the dollars in a ris38free asset for a
year0 and then converting the dollars )ac3 to pesos at the end of one year-
Do yo" thin3 the rate of ret"rn on Ed6s investment *ill )e higher than0 lo*er than0 or the same as
the rate of ret"rn on 4aria6s investment9 Explain-
A.WER= 4aria6s rate of ret"rn *ill )e higher- .ince interest rate parity exists0 she *ill earn
*hatever the local ris38free interest rate is in 4exico- Ed6s expected rate of ret"rn is *hatever the
ris38free rate is in the U-.- +)ased on the I$E,-
0/. Ar)itrage and PPP. Ass"me that locational ar)itrage ens"res that spot exchange rates are properly
aligned- Also ass"me that yo" )elieve in p"rchasing po*er parity- The spot rate of the British
po"nd is F%-A&- The spot rate of the .*iss franc is -: po"nds- 2o" expect that the one8year
inflation rate is > percent in the U-G-0 ' percent in .*it1erland0 and % percent in the U-.- The one8
year interest rate is (N in the U-G-0 7N in .*it1erland0 and <N in the U-.- What is yo"r expected
spot rate of the .*iss franc in one year *ith respect to the U-.- dollar9 .ho* yo"r *or3-
A.WER= .$ spot rate in F M %-A& H -: M F-'<-
Expecte N change in .$ in one year M +%-&%,P+%-&', K % M K:-AN
Expected spot rate of .$ in one year M F-'< H +% K -&:A, M F'%-B<
00. IRP ;ersus IE. 2o" )elieve that interest rate parity and the international $isher effect hold-
Ass"me the U-.- interest rate is presently m"ch higher than the e* Realand interest rate- 2o" have
receiva)les of % million e* Realand dollars that yo" *ill receive in one year- 2o" co"ld hedge the
receiva)les *ith the one8year for*ard contract- !r yo" co"ld decide to not hedge- Is yo"r expected
U-.- dollar amo"nt of the receiva)les in one year from hedging higher0 lo*er0 or the same as yo"r
expected U-.- dollar amo"nt of the receiva)les *itho"t hedging9 Explain-
A.WER= The expected amo"nt is the same0 )eca"se the for*ard rate reflects the interest rate
differential0 and the expected spot rate +if yo" do not hedge, according to I$E reflects the interest
rate differential-
01. IRP, PPP, and 7peculating in Currency (eri:ati:es. The U-.- three8month interest rate
+"nann"ali1ed, is %N- The 5anadian three8month interest rate +"nann"ali1ed, is <N- Interest rate
parity exists- The expected inflation over this period is 'N in the U-.- and 7N in 5anada- A call
option *ith a three8month expiration date on 5anadian dollars is availa)le for a premi"m of F-&7
and a stri3e price of F-(<- The spot rate of the 5anadian dollar is F-('- Ass"me that yo" )elieve in
p"rchasing po*er parity-
a- Determine the dollar amo"nt of yo"r profit or loss from )"ying a call option contract specifying
5F%&&0&&&-
Chapter 8: Relationships Among Inflation, Interest Rates, and Exchange Rates %%B
A.WER= The expected change in the 5anadian dollar6s spot rate is=
+%-&',P+%-&7, K % M 7-B<N-
Therefore0 the expected spot rate in : months is F-(' H +%-&7B<, M F-((B%%-
The net profit per "nit on a call option is F-((B%% K F-(< K F-&7 M F-&&B%%-
$or the contract0 the net profit is F-&&B%% H %&&0&&& M FB%%-
)- Determine the dollar amo"nt of yo"r profit or loss from )"ying a f"t"res contract specifying
5F%&&0&&&-
A.WER= According to IRP0 the f"t"res rate premi"m sho"ld )e +%-&%,P+%-&<, K % M K7-AAN
Therefore0 the f"t"res rate sho"ld )e F-(' H +% K -&7AA, M F-(:%:-
Recall that the expected spot rate in : months is F-(' H +%-&7B<, M F-((B%%- The expected net profit
per "nit from )"ying a f"t"res contract is F-((B%% K F-(:%: M F-&:>A%- $or the contract0 the net
profit is F-&:>A% H %&&0&&& M F<0:<%-
Solution to Continuing Case Problem !lades" #nc$
%- What is the relationship )et*een the exchange rates and relative inflation levels of the t*o
co"ntries9 ?o* *ill this relationship affect Blades6 Thai reven"e and costs given that the )aht is
freely floating9 What is the net effect of this relationship on Blades9
A.WER= The relationship )et*een exchange rates and relative inflation rates is s"mmari1ed )y
the p"rchasing po*er parity +PPP, theory- When one co"ntry6s inflation rate rises relative to that of
another0 the demand for the former co"ntry6s c"rrency declines as its exports decline +d"e to its
higher prices,- $"rthermore0 cons"mers and firms in the co"ntry *ith higher inflation tend to
increase their importing- Th"s0 the a)sol"te form of PPP states that prices of similar prod"cts of
t*o different co"ntries sho"ld )e e;"al *hen meas"red in a common c"rrency- The relative form of
PPP states that prices of similar prod"cts of different co"ntries *ill not necessarily )e the same
*hen meas"red in a common c"rrency )eca"se of mar3et imperfections- ?o*ever0 it states that the
rate of change in the prices of prod"cts sho"ld )e similar- Both forms of the theory s"ggest that the
c"rrency of the co"ntry *ith the higher level of inflation sho"ld depreciate to offset the inflation
differential-
.ince the )aht has )ecome a freely floating c"rrency0 the c"rrency sho"ld )e expected to depreciate
d"e to the high inflation levels prevailing in Thailand- Blades6 reven"e generated in Thailand *ill )e
negatively affected )y PPP- Beca"se of Blades6 export arrangement0 it is "na)le to increase its
prices in line *ith Thai levels of inflation- ?o*ever0 since Blades6 exports are denominated in )aht0
a depreciation of the )aht *ill res"lt in a conversion of )aht into fe*er dollars- Blades6 cost of
goods sold generated in Thailand *ill increase as Thai exporters ad/"st their prices according to
Thai inflation rates- ?o*ever0 the high prices res"lting from high levels of inflation in Thailand may
)e some*hat offset )y a depreciation of the )aht-
.ince Blades generates net cash inflo*s from its Thai operations0 it *ill )e negatively affected )y
PPP-
%7& International Financial Management
7- What are some of the factors that prevent PPP from occ"rring in the short r"n9 Wo"ld yo" expect
PPP to hold )etter if co"ntries negotiate trade arrangements "nder *hich they commit themselves to
the p"rchase or sale of a fixed n"m)er of goods over a specified time period9 Why or *hy not9
A.WER= PPP may not hold )eca"se exchange rates are affected )y other factors in addition to
the inflation differential )et*een t*o co"ntries0 s"ch as relative interest rates0 national income
levels0 and government controls- $"rthermore0 certain goods may not )e affected )y PPP )eca"se no
s"ita)le s")stit"tes are availa)le in the home co"ntry- Th"s0 the trade relationships )et*een t*o
co"ntries for these goods may not )e affected )y inflation rate differentials in the manner s"ggested
)y PPP-
Arrangements *here)y firms *ith differing inflation commit themselves to the p"rchase of a fixed
n"m)er of goods over a specified period of time *ill ca"se PPP not to hold0 at least in the short r"n-
This is )eca"se contract"al agreements are not easily terminated0 ca"sing a delayed impact of
inflation rates on trade relationships and0 conse;"ently0 exchange rates-
:- ?o* do yo" reconcile the high level of interest rates in Thailand *ith the expected change of the
)aht8dollar exchange rate according to PPP9
A.WER= ?igh levels of real interest rates in a given co"ntry may increase the demand for that
co"ntry6s c"rrency as foreign investors can earn higher rates of ret"rn in the foreign co"ntry than
may )e availa)le domestically- This *o"ld place "p*ard press"re on the c"rrency of the co"ntry
*ith the higher level of real interest rates- ?o*ever0 the high level of nominal interest rates in
Thailand are primarily the res"lt of high expected levels of Thai inflation- Therefore0 according to
the international $isher effect +I$E,0 the Thai )aht sho"ld depreciate )y an amo"nt s"fficient to
offset the nominal interest rate differential )et*een Thailand and the U-.-
<- Given Blades6 f"t"re plans in Thailand0 sho"ld the company )e concerned *ith PPP9 Why or *hy
not9
A.WER= Altho"gh PPP may not hold *ell in the short r"n0 it has )een fo"nd to hold reasona)ly
*ell in the long r"n- .ince Blades is "nder a three8year export arrangement *ith Entertainment
Prod"cts0 Inc- and since it is considering the expansion into Thailand0 the company sho"ld )e
concerned *ith PPP@ in the long r"n0 the relatively high level of Thai inflation may res"lt in a
depreciation of the )aht s"fficient to offset the inflation differential- 2et0 Blades *ill )e a)le to
renegotiate its arrangement once the three8year period for the existing arrangement is over-
'- PPP may hold )etter for some co"ntries than for others- Given that the Thai )aht has )een freely
floating for only a short period of time0 ho* do yo" thin3 Blades can gain insight into *hether PPP
*ill hold for Thailand9
A.WER= !ne possi)le *ay to determine *hether PPP holds )et*een t*o co"ntries is to regress
historical exchange rate changes on the inflation differential )et*een t*o co"ntries- ?o*ever0 this
form of testing *hether PPP holds is not appropriate for Thailand0 since the )aht has only )een
freely floating for a short period of time@ *hen the )aht *as pegged to the dollar0 the )aht8dollar
exchange rate *as not affected )y the inflation rates in the t*o co"ntries-
!ne possi)le alternative is to investigate0 via regression analysis0 *hether PPP holds )et*een the
U-.- and a co"ntry similar to Thailand in terms of inflation rates0 other economic characteristics0
and trade relationships *ith the U-.- The regression res"lts co"ld then )e "sed to assess ho* the
)aht8dollar exchange rate may )e affected )y the inflation differential )et*een the U-.- and
Thailand in the f"t"re-
Chapter 8: Relationships Among Inflation, Interest Rates, and Exchange Rates %7%
Solution to Supplemental Case %lame %i&tures" #nc$
a- If the peso depreciates )y more than the inflation differential0 then the dollar cost to $lame *ill )e
even lo*er than expected-
)- If the peso depreciates )y less than the inflation differential0 then the dollar cost to $lame *ill )e
even higher than expected- 5onsider a scenario in *hich the 4exican inflation rate is A& percent or
so0 ca"sing the )ill in pesos to )e A& percent higher- 2et0 if the peso depreciated )y a relatively
small amo"nt over this period +say 7& percent or so,0 the dollar cost to $lame *ill increase
s")stantially- .ince there are other factors in addition to inflation that also affect the peso6s
exchange rate0 the peso *ill not necessarily depreciate )y an amo"nt that f"lly offsets the high
inflation-
c- .ta)le dollar payments *o"ld only occ"r if the peso depreciated )y an amo"nt that offset its high
inflation rate- It is "nli3ely that there *ill )e a perfect offset in any given period- Therefore0
$lame6s dollar payments *o"ld )e "nsta)le0 and so *o"ld its profits-
d- The ris3 *o"ld increase0 )eca"se its payments for parts *o"ld no* )e more volatile0 and so *o"ld
its profits- Given that it does not have m"ch li;"idity0 it *ill s"ffer a cash s;"ee1e if the peso does
not depreciate m"ch *hile 4exican inflation is high- !ver the long r"n0 there may )e periods in
*hich this happens- $lame *o"ld )e loc3ed into this arrangement *ith 5oron for ten years0 and
therefore cannot )ac3 o"t0 even if the peso6s depreciation does not offset the inflation differential-
Small !usiness Dilemma
Assessment of the IE )y the 7ports Exports Company
%- Is Eim6s interpretation of the I$E theory correct9
A.WER= 2es- The expected f"t"re spot rate derived from the I$E theory is the same as the
for*ard rate- Th"s0 the res"lts from selling po"nds at the f"t"re spot rate +*hen not hedging,
sho"ld )e e;"al to the res"lts from selling the po"nds for*ard +*hen hedging, on average if the I$E
theory holds-
7- If yo" *ere in Eim6s position0 *o"ld yo" spend time trying to decide *hether to hedge the
receiva)les each month0 or do yo" )elieve that the res"lts *o"ld )e the same +on average, *hether
yo" hedged or not9
A.WER= There is some ;"estion as to *hether the I$E theory holds- Therefore0 it is naive to
thin3 that the res"lts *ill )e the same on average *hether one hedges or does not hedge- ?o*ever0
it is possi)le that one co"ld do *orse )y ma3ing the hedge vs- no8hedge decision each month0 )"t
most managers *o"ld attempt to ma3e the decision rather than ignore it-
Part '(#ntegrative Problem
Exchange Rate 9eha:ior
%- As an employee of the foreign exchange department for a large company0 yo" have )een given the
follo*ing information-
%77 International Financial Management
Beginning of 2ear
.pot rate of S M F%-'B(
.pot rate of A"stralian dollar +AF, M F->&
5ross exchange rate= S% M AF7-7A
!ne8year for*ard rate of AF M F->%
!ne8year for*ard rate of S M F%-'A&&<
!ne8year U-.- interest rate M A-&&N
!ne8year British interest rate M B-&BN
!ne8year A"stralian interest rate M >-&&N
Determine *hether triang"lar ar)itrage is feasi)le0 and if so0 ho* it sho"ld )e cond"cted to ma3e a
profit-
A.WER= Triang"lar ar)itrage is not feasi)le )eca"se the cross exchange rate )et*een S and AF
is properly specified=
Proper 5ross exchange rate M
.pot rate of S
.pot rate of AF
M
F%-'B(
F->
M 7-7A
7- Using the information in ;"estion %0 determine *hether covered interest ar)itrage is feasi)le and0 if
so0 ho* it sho"ld )e cond"cted to ma3e a profit-
A.WER= 5overed interest ar)itrage is only feasi)le *hen interest rate parity does not exist- To
test *hether interest rate parity exists0 determine the for*ard premi"m that sho"ld exist for the
po"nd and for the A"stralian dollar-
Chapter 8: Relationships Among Inflation, Interest Rates, and Exchange Rates %7:
$or*ard Premi"m Act"al
5"rrency that .ho"ld Exist $or*ard Premi"m
Po"nd +S,
( )
( )
% 8
i J %
i J %
M p
f
h
p M
$ 8 .
.

( )
( )
M
%-&A
%-&B&B
8 % M
F%-'A&&< 8 F%-'B(
F%-'B(
M K-&% M K-&%
A"stralian Dollar +AF,
( )
( )
p M
%J i
%J i
8 %
h
f
p M
$ 8 .
.

( )
·
%-&A
%-&>
8 %
·
->% 8 F->&
F->&
M -&&B: M -&%<7A
Interest rate parity exists for the British po"nd- ?o*ever0 interest rate parity does not exist for the
AF- The act"al for*ard premi"m is higher than it sho"ld )e- U-.- investors co"ld )enefit from the
discrepancy )y "sing covered interest ar)itrage- The for*ard premi"m they *o"ld receive *hen
selling AF at the end of one year more than offsets the interest rate differential- While the U-.-
investors receive % percent less interest on the A"stralian investment0 they receive %-<7A percent
more *hen selling AF than *hat they initially pay for AF-
:- Based on the information in ;"estion % for the )eginning of the year0 "se the international $isher
effect +I$E, theory to forecast the ann"al percentage change in the British po"nd6s val"e over the
year-
A.WER= The I$E s"ggests that given t*o c"rrencies0 the c"rrency *ith a higher interest rate
reflects higher expected inflation0 *hich *ill place do*n*ard press"re on the val"e of that c"rrency
+)ased on p"rchasing po*er parity,- The c"rrency ad/"stment *ill offset the differential in interest
rates-
( )
( )
( )
( )
e M
% J i
% J i
8 %
M
% J -&A
% J -&B&B
8 %
8-&% or 8%N
f
h
f
T

Th"s0 the po"nd *as expected to depreciate )y % percent over the year0 )ased on the I$E-
<- Ass"me that at the )eginning of the year0 the po"nd6s val"e is in e;"ili)ri"m- Ass"me that over the
year the British inflation rate is ( percent *hile the U-.- inflation rate is < percent- Ass"me that
%7< International Financial Management
any change in the po"nd6s val"e d"e to the inflation differential has occ"rred )y the end of the year-
Using this information and the information provided in ;"estion %0 determine ho* the po"nd6s val"e
changed over the year-
A.WER= If PPP held0 the po"nd *o"ld have changed )y=
e M
% J I
% J I
8 %
M
%-&<
%-&(
8 %
8 -&%AB or 8 %-ABN

p
h
f
¸
¸

_
,

T
'- Ass"me that the po"nd6s depreciation over the year *as attri)"ted directly to central )an3
intervention- Explain the type of direct intervention that *o"ld place do*n*ard press"re on the
val"e of the po"nd-
A.WER= If central )an3s "sed po"nds to p"rchase dollars in the foreign exchange mar3et0 they
*o"ld place do*n*ard press"re on the po"nd6s val"e-