Chapter 8 Relationships among Inflation, Interest Rates, and Exchange Rates

Purchasing Power Parity (PPP) y y PPP attempts to quantify the inflation-exchange rate relationship Absolute Form PPP Without international barriers consumers shift their demand to wherever prices are lower. The prices of the basket of products in two different should be equal when measured in a common currency. Relative Form of PPP Because of market frictions (tariffs, transportation costs and quotas) prices of the same basket of products in different countries will not necessarily be the same when measured in a common currency.

y

With inflation home country price index become

Phome (1+Ihome) Pforeign (1+Iforeign)

Price index of foreign country will change with inflation h = home country f = foreign country

I = inflation rate

With inflation the foreign country price index from the perspective of the home country becomes Pforeign (1+Iforeign)(1 + eforeign) e =% change in foreign currency to home According to Purchasing Power Parity (PPP) the new price index of home country with inflation should equal the new price index of foreign country Phome (1+Ihome) = Pforeign (1+Iforeign)(1 + eforeign) Solving for e (assume Phome = Pforeign initially) % change in value of the foreign currency exchange rate will depend on the rates of expected inflation in the two countries e =% change in foreign exchange rate = (1 + Ih) / (1 + If) h = home country y f = foreign country - 1

I = inflation rate

Assume the exchange of two countries is in equilibrium. Then the home country experiences 5% inflation and the foreign country experiences a 3% rate.

% change in foreign currency to home =

1

One year risk free yield in USA = 4% One year risk free yield in Japan =2% Spot Yen $.21. According to PPP. INT. GC. EXP) e = percentage change in the spot rate. the Singapore dollar should ____ by ____%. According to PPP Adjusted Spot Rate = Spot(1 + Ih) / (1 + If) PPP Does Not Occur because of confounding effects and lack of substitutes for some traded goods Remember exchange rates are driven by more than inflation e = f ( INF. When the investor repurchases his home currency the exchange rates should have adjusted so you only make the return of home country. Also investing in another country with higher interest rates will not give any higher return than the investor s home country after adjusting for inflation. If the market s guess about inflation is buried in the interest rate of a country and each country has the same real rate of interest then investing in another country with a higher interest rate may not be beneficial.S. is 8%. The change in exchange rates should reflect the change in inflation and the exchange rate adjust based on that. May not happen. INC. INF = Change in differential of inflation between countries INT = Change in differential in interest between countries INC = Change in income levels of US and foreign country GC = Change in government controls EXP = Change in expectations of future exchange rate For PPP to work if the price of an import becomes too high the consumer will switch to a substitute. while the inflation rate in the U. International Fisher Effect (IFE) y Use interest rates rather than inflation rates to explain why exchange rates fluctuate over time. Assume that the inflation rate in Singapore is 3%.021/Yen 2 . Risk Free interest ratenominal = (1 + real rate) (1 + expected inflation rate) 1 Fisher Effect Interest rates in two countries differ because of differences in inflation rates which are buried in the interest rates. (Like PPP).

Same formula as forward markets with interest rate parity (IRP). International Fisher Effect Future Spot Rate = Spot Rate [(1+Interest Ratehome)/(1+Interest RateForeign)] Change in Spot Rate e = [(1+Interest Ratehome)/(1+Interest RateForeign)] . IFE. If the spot rate of the euro in one year is $1. while one-year interest rates in the U.S. Integrating IRP and IFE.00.000 to euros and invests them in Germany. Beth Miller does not believe that the international Fisher effect (IFE) holds. The current spot rate of the euro is $1. and Europe: U.10 a. What must the spot rate of the euro be in one year for Beth¶s strategy to be successful? 25.If the yields reflect the actual inflation over the year what is the exchange rate in one year. According to the IFE. Beth converts $100. Assume the following information is available for the U. One year later.S.S.13 $1. If the spot rate of the euro in one year is $1. Current one-year interest rates in Europe are 5 percent. what is Beth¶s percentage return from her strategy? c. what should the spot rate of the euro in one year be? b. are 3 percent.08. she converts the euros back to dollars. Nominal interest rate Expected inflation Spot rate One-year forward rate 4% 2% --------- Europe 6% 5% $1. what is Beth¶s percentage return from her strategy? d. Does IRP hold? 3 .1 24.10. a.

Based on the international Fisher effect. According to the IFE. IRP. what is the expected spot rate of the euro in one year? c.20 $. As of today. What is the 1-year forward rate of the peso? c. According to PPP. what is the expected change in the spot rate over the next year? d. Real rate of interest required by investors Nominal interest rate Spot rate One-year forward rate 2% 11% ² ² Mexico 2% 15% $. 26. a. The 1-year risk-free rate in the United States is 2 percent. What is the forward rate premium? b. The spot rate of the Mexican peso is $. If the spot rate changes as expected according to the IFE. Deriving Forecasts of the Future Spot Rate.S.14. Assume that interest rate parity exists. The I-year risk-free interest rate in Mexico is 10 percent.b.19 4 . Compare your answers to (b) and (d) and explain the relationship 20. what is the expected spot rate of the euro in one year? . what will be the spot rate in 1 year? e. assume the following information is available: U.

What do you think the spot rate of the Canadian dollar will be in one year? 5 . 35. one-year interest rate is 6%. 39. Wake Forest Co. The U. Assume you believe in purchasing power parity. Use the forward rate to forecast the percentage change in the Mexican peso over the next year.S. b. You believe the real one-year interest rate is 2% in the U. Today the Canadian dollar spot rate at $. Use the spot rate to forecast the percentage change in the Mexican peso over the next year.S. inflation rate over this year is expected to be 7%.10. PPP and Real Interest Rates. while the nominal one-year interest rate in Canada is 5%. Use the differential in expected inflation to forecast the percentage change in the Mexican peso over the next year. Assume that purchasing power parity holds. The nominal (quoted) U.90. Determine the expected amount of dollars to be paid by the Wake Forest Co. while the Mexican inflation over this year is expected to be 3%. and that the real one-year interest rate is 3% in Canada. for the pesos in one year. Implications of PPP.S. Today¶s spot rate of the Mexican peso is $. c. plans to import from Mexico and will need 20 million Mexican pesos in one year.a.