International Financial Management

Abridged 10th Edition

by Jeff Madura

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 8
Relationships among Inflation, Interest Rates and
Exchange Rates
Chapter Objectives
This chapter will:
A. Explain the purchasing power parity (PPP) theory and its
implications for exchange rate changes
B. Explain the International Fisher effect (IFE) theory and its
implications for exchange rate changes
C. Compare the PPP theory, the IFE theory, and the theory of
interest rate parity (IRP), which was introduced in the
previous chapter

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 Purchasing Power Parity (PPP)

1. Interpretation of Purchasing Power Parity

a. Absolute Form of PPP: without international barriers,
consumers shift their demand to wherever prices are lower.
Prices of the same basket of products in two different
countries should be equal when measured in common
currency.
b. Relative Form of PPP: Due to market imperfections, prices
of the same basket of products in different countries will not
necessarily be the same when measured in a common
currency. However, the rate of change in prices should be
somewhat similar when measured in common currency as
long as transportation costs and trade barriers are unchanged.

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 Purchasing Power Parity

1. Relationship between relative inflation rates (I) and

the exchange rate (e).
1 Ih
ef  1
1 I f

2. Simplified PPP relationship

e f  Ih  I f

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 8.1 Summary of Purchasing Power Parity

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 8.2 Illustration of Purchasing Power Parity

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 8.3 Identifying Disparity in Purchasing Power

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Testing the Purchasing Power Parity Theory

1. Conceptual tests of PPP

2. Statistical Test of PPP
3. Results of Tests of PPP
4. Tests of PPP for each currency
5. Limitation of PPP Tests

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 Exhibit 8.4 Comparison of Annual Inflation Differentials
and Exchange Rate Movements For Four Major Currencies

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 Why Purchasing Power Parity Does Not
Occur
1. Confounding effects
2. No substitutes for traded goods

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 International Fisher Effect (IFE)

1. IFE suggests that the nominal interest rate contain

two components:
a. Expected inflation rate
b. Real interest rate
2. Implications of the IFE: currencies with high interest
rates will have high expected inflation and will be
expected depreciate.
3. Implications of the IFE for foreign investors: foreign
investors will be adversely affected by the effects of
relatively high U.S. inflation rate if they try to
capitalize on high U.S. interest rates.

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Derivation of the International Fisher Effect

1. Relationship between the interest rate (i) differential

between two countries and expected exchange rate (e)
1  ih
ef  1
1 i f

2. Simplified relationship

e f  ih  i f

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 8.6 Summary of the International Fisher Effect

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 8.7 Illustration of IFE Line (When Exchange Rate
Changes Perfectly Offset Interest Rates Differentials)

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 8.9 Comparison of the IRP, PPP, and IFE
Theories

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.