ppp

C HA P T E R 8C HA P T E R 8

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

RatesRates

Chapter OverviewChapter Overview

A. Purchasing Power Parity (PPP)A. Purchasing Power Parity (PPP)

B. International Fisher Effect (IFE)B. International Fisher Effect (IFE)

C. Comparison of the IRP, PPP, C. Comparison of the IRP, PPP, and and IFE TheoriesIFE Theories

Chapter 8 ObjectivesChapter 8 Objectives

This chapter will:This chapter will:A. Explain the purchasing power parity (PPP) A. Explain the purchasing power parity (PPP)

theory and its implications for exchange theory and its implications for exchange rate changesrate changes

B. Explain the International Fisher effect B. Explain the International Fisher effect (IFE) theory and its implications for (IFE) theory and its implications for exchange rate changesexchange rate changes

C. Compare the PPP theory, the IFE theory, C. Compare the PPP theory, the IFE theory, and the theory of interest rate parity and the theory of interest rate parity

(IRP), which was introduced in the (IRP), which was introduced in the previous chapterprevious chapter

A. Purchasing Power Parity (PPP) TheoryA. Purchasing Power Parity (PPP) TheoryPPPPPP – PPP tries to quantify the inflation and exchange rate – PPP tries to quantify the inflation and exchange rate

relationship - exchange rate movements are caused by inflation relationship - exchange rate movements are caused by inflation rate differentialsrate differentials..

1. Interpretations of Purchasing Power Parity1. Interpretations of Purchasing Power Paritya.a. Absolute Form of PPP Absolute Form of PPP - Prices of the same basket of products - Prices of the same basket of products

in two different countries should be equal when measured in in two different countries should be equal when measured in a common currency. a common currency.

b.b. Relative Form of PPP Relative Form of PPP - The rate of change in the prices of - The rate of change in the prices of the baskets should be somewhat similar when measured in a the baskets should be somewhat similar when measured in a common currency, as long as the transportation costs and common currency, as long as the transportation costs and trade barriers are unchanged.trade barriers are unchanged.

2. Rationale behind Purchasing Power Parity Theory2. Rationale behind Purchasing Power Parity TheoryIf two countries produce products substitutable for each other, If two countries produce products substitutable for each other, the demand for the products should adjust as inflation rates the demand for the products should adjust as inflation rates differ.differ.

A. Purchasing Power Parity (PPP)A. Purchasing Power Parity (PPP)3. Derivation of Purchasing Power Parity3. Derivation of Purchasing Power Parity The foreign currency will depreciate when the foreign The foreign currency will depreciate when the foreign

country’s inflation exceeds the home country’s inflation.country’s inflation exceeds the home country’s inflation.

4. Using PPP to Estimate Exchange 4. Using PPP to Estimate Exchange Rate EffectsRate Effectsa. Using a Simplified PPP Relationship: ea. Using a Simplified PPP Relationship: e ff = I = Ihh – I – Iff

5. Graphic Analysis of Purchasing Power Parity5. Graphic Analysis of Purchasing Power Parity

- - Potential impact of inflation on exchange ratesPotential impact of inflation on exchange rates

a. PPP Line – a. PPP Line – relationship between inflation rates relationship between inflation rates differentials and the exchange rate between two countries differentials and the exchange rate between two countries

b. Purchasing Power Disparity b. Purchasing Power Disparity – If the exchange rate does – If the exchange rate does not move even though there is a change in the inflation not move even though there is a change in the inflation rates of two countries, there is a disparity in the rates of two countries, there is a disparity in the purchasing power of the two countries. purchasing power of the two countries.

8.18.1

Illustration of Purchasing Power Parity

8.28.2

Identifying Disparity in Purchasing Power


6. Testing the Purchasing Power Parity Theory6. Testing the Purchasing Power Parity Theory a. Conceptual Tests of PPPa. Conceptual Tests of PPP

1) choose two countries (US and a foreign 1) choose two countries (US and a foreign country) country)

2) compare the2) compare the differential in their inflation rates differential in their inflation rates to to the percentage change in the foreign the percentage change in the foreign currency’s currency’s

value during several time periods. value during several time periods.


b. Statistical Test of PPP – b. Statistical Test of PPP – can be developed by can be developed by applying regression analysis to historical exchange rates applying regression analysis to historical exchange rates and inflation differentialsand inflation differentials

c. Results of Tests of PPP – c. Results of Tests of PPP – mixed. Some supports mixed. Some supports the theory and others do not.the theory and others do not.

d. Tests of PPP for Each Currency –d. Tests of PPP for Each Currency – The The percentage changes in exchange rates are typically percentage changes in exchange rates are typically much more volatile than the inflation differentials. The much more volatile than the inflation differentials. The relationship between inflation differentials and exchange relationship between inflation differentials and exchange

rate movements often becomes distorted. rate movements often becomes distorted. e. Limitations of PPP Testse. Limitations of PPP Tests – It is very difficult to – It is very difficult to

choose the equilibrium base period used.choose the equilibrium base period used.

8.38.3

Comparison of Annual Inflation Differentials and Exchange Rate MovementsFor Four Major Currencies


7. Why Purchasing Power Parity Does Not Occur7. Why Purchasing Power Parity Does Not Occura. Confounding Effects – a. Confounding Effects – There are also other There are also other

factors factors (interest rate, national income, (interest rate, national income, government control, government control, and expectations of future and expectations of future exchange rates) affecting exchange rates) affecting the exchange rates.the exchange rates.

b. No Substitutes for Traded Goods – b. No Substitutes for Traded Goods – If substitute If substitute goods are not available domestically, consumers goods are not available domestically, consumers

may may not stop buying imported goods.not stop buying imported goods.


8. Purchasing Power Parity in the Long Run8. Purchasing Power Parity in the Long RunAbuaf and Jorion study: a. suggest that deviations from PPP are substantial in the short run but are reduced by about half in 3 years. b. even though exchange rates deviate from the levels predicted by PPP in the short run, their deviations are reduced over the long run.

B. International Fisher Effect (IFE) TheoryB. International Fisher Effect (IFE) Theory

IFEIFE explains the relationship between interest rate and exchange explains the relationship between interest rate and exchange rate changes over time.rate changes over time.

IFE -IFE - Nominal risk-free interest rates contain a real rate of return and Nominal risk-free interest rates contain a real rate of return and anticipated inflation.anticipated inflation.

1.1. Relationship with Purchasing Power ParityRelationship with Purchasing Power ParityForeign currencies with relatively high interest rates willForeign currencies with relatively high interest rates will

depreciatedepreciate because the high nominal interest rates reflect because the high nominal interest rates reflect

expected inflation. IFE disagrees with the notion that highexpected inflation. IFE disagrees with the notion that high

interest rate will appreciate the currency because it attractsinterest rate will appreciate the currency because it attracts

the investors.the investors.

2. Implications of the IFE for Foreign Investors2. Implications of the IFE for Foreign InvestorsForeign investors will be adversely affected by the effects of a Foreign investors will be adversely affected by the effects of a relatively high US inflation rate if they try to capitalize on the high relatively high US inflation rate if they try to capitalize on the high US interest rate.US interest rate.

B. International Fisher Effect (IFE)B. International Fisher Effect (IFE)3. Derivation of the International Fisher Effect 3. Derivation of the International Fisher Effect

(relationship between interest rate differential between (relationship between interest rate differential between two countries and the expected exchange rate change)two countries and the expected exchange rate change)

- Actual return to investors who invest in a foreign security Actual return to investors who invest in a foreign security depends on not only the foreign interest rate, but also the depends on not only the foreign interest rate, but also the percentage change in the value of the foreign currency percentage change in the value of the foreign currency denominating the security.denominating the security.

a. Numerical Example based on the Derivation of IFEa. Numerical Example based on the Derivation of IFE 1 + i1 + ihh

eef f = ------- - 1= ------- - 11+ i1+ iff

b. Simplified Relationship: eb. Simplified Relationship: eff = i = ihh – i – iff


4. Graphic Analysis of the International 4. Graphic Analysis of the International Fisher EffectFisher Effect

a. Points on the IFE Line – a. Points on the IFE Line – Exchange rate Exchange rate adjustments offset the differential in interest rates – adjustments offset the differential in interest rates – same return whether they invest at home of in a same return whether they invest at home of in a foreign country foreign country

b. Points below the IFE Line (G) – b. Points below the IFE Line (G) – higher higher returns from investing in foreign deposits returns from investing in foreign deposits

c. Points above the IFE Line (J, H)– c. Points above the IFE Line (J, H)– lower lower returns from investing in foreign deposits compared returns from investing in foreign deposits compared

to domestically invested returnsto domestically invested returns

8.58.5

Illustration of IFE Line (When Exchange Rate Changes Perfectly Offset InterestRates Differentials)


5. Test of the International Fisher Effect – 5. Test of the International Fisher Effect – Interest rate differentials are, on average, offset by Interest rate differentials are, on average, offset by changes in the exchange rates. Thus, foreign investments changes in the exchange rates. Thus, foreign investments have generated yields that are, on average, equal to have generated yields that are, on average, equal to those of domestic investments.those of domestic investments.

a. Results from testing the IFE - a. Results from testing the IFE - MixedMixed

b. Statistical Test of the IFE using a b. Statistical Test of the IFE using a regression analysis regression analysis


6. Why the international Fisher Effect 6. Why the international Fisher Effect Does Not OccurDoes Not Occur

a. PPP does not hold in certain a. PPP does not hold in certain timestimes

b. Since IFE based on PPP, it doesb. Since IFE based on PPP, it does

not hold consistently eithernot hold consistently either

C. Comparison of the IRP, PPP, C. Comparison of the IRP, PPP, and IFE Theoriesand IFE Theories

8.78.7

Blades, Inc Case StudyBlades, Inc Case Study1. a) Relationship between exchange rates and inflation. B) impact 1. a) Relationship between exchange rates and inflation. B) impact

on Blades’ rev and cost, c) net effect – ppp theory and impact on Blades’ rev and cost, c) net effect – ppp theory and impact of exchange rate movement on its rev (fixed) and costof exchange rate movement on its rev (fixed) and cost

2. a) other factors, besides inflation, affecting exchange rate in 2. a) other factors, besides inflation, affecting exchange rate in short term, b) PPP under a fixed sales/purchase agreement, c) short term, b) PPP under a fixed sales/purchase agreement, c) why or why not? – other factors and condition where ppp why or why not? – other factors and condition where ppp works.works.

3. Relationship between interest rate and exchange rate per 3. Relationship between interest rate and exchange rate per PPP/IFE. Difference between real interest rate and nominal PPP/IFE. Difference between real interest rate and nominal interest (real interest rate + expected inflation rate) – high interest (real interest rate + expected inflation rate) – high interest rate depreciates the currency.interest rate depreciates the currency.

4. 3 year commitment plus future plan (expansion of its presence), 4. 3 year commitment plus future plan (expansion of its presence), and high inflationand high inflation

5. Any way to check the PPP’s validity for Thailand? Why may PPP 5. Any way to check the PPP’s validity for Thailand? Why may PPP not work for Thailand?not work for Thailand?

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