International Financial Management

13th Edition
by Jeff Madura

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 Relationships among Inflation, Interest
8 Rates and Exchange Rates
Chapter Objectives
 Explain the purchasing power parity (PPP) theory and
its implications for exchange rate changes.

 Explain the International Fisher effect (IFE) theory and

its implications for exchange rate changes.

2
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 Purchasing Power Parity (PPP) (1 of 10)

Interpretations of Purchasing Power Parity

 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.
 Relative Form of PPP: Due to market imperfections,
prices of the same basket of products in different
countries will not necessarily be the same, but the
rate of change in prices should be similar when
measured in common currency

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 Purchasing Power Parity (PPP) (2 of 10)

Rational Behind Relative PPP Theory

 Exchange rate adjustment is necessary for the
relative purchasing power to be the same whether
buying products locally or from another country.
 If the purchasing power is not equal, consumers
will shift purchases to wherever products are
cheaper until the purchasing power is equal.

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 Purchasing Power Parity (PPP) (3 of 10)

Derivation of Purchasing Power Parity

Relationship between relative inflation rates (I) and
the exchange rate (e).
1 Ih
ef  1
1 I f

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 Purchasing Power Parity (PPP) (4 of 10)

Using PPP to Estimate Exchange Rate Effects

 The relative form of PPP can be used to estimate
how an exchange rate will change in response to
differential inflation rates between countries.
 International trade is the mechanism by which the
inflation differential affects the exchange rate
according to this theory (Exhibit 8.1)
 Using a simplified PPP relationship:
e f  Ih  I f
 The percentage change in the exchange rate should
be approximately equal to the difference in inflation
rates between the two countries.

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 Exhibit 8.1 Summary of Purchasing Power Parity

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 Purchasing Power Parity (PPP) (5 of 10)

Graphic Analysis of Purchasing Power Parity

 Using PPP theory, we should be able to assess the
potential impact of inflation on exchange rates. The
points on Exhibit 8.2 suggest that given an inflation
differential between the home and the foreign country
of X percent, the foreign currency should adjust by X
percent due to that inflation differential.
 PPP Line — The diagonal line connecting all these
points together.

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 Exhibit 8.2 Illustration of Purchasing Power Parity
and Disparity

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 Purchasing Power Parity (PPP) (6 of 10)

Graphic Analysis of Purchasing Power Parity (cont.)

 Purchasing Power Disparity
 Any points off of the PPP line represent purchasing power
disparity. If the exchange rate does not move as PPP
theory suggests, there is a disparity in the purchasing
power of the two countries.
 Point C in Exhibit 8.2 represents a situation where home
inflation (Ih) exceeds foreign inflation (If ) by 4%. Yet, the
foreign currency appreciated by only 1% in response to
this inflation differential. Consequently, purchasing power
disparity exists.

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 Purchasing Power Parity (PPP) (7 of 10)

Testing the Purchasing Power Parity Theory

 Simple test of PPP
 Choose two countries (such as the United States and a
foreign country) and compare the differential in their inflation
rates to the percentage change in the foreign currency’s
value during several time periods. This simple test of PPP is
applied to four different currencies from a U.S. perspective in
Exhibit 8.3.
 Statistical Test of PPP
 Apply regression analysis to historical exchange rates and
inflation differentials.
 Results of Statistical Tests of PPP
 Deviations from PPP are not as pronounced for longer time
periods, but they still exist. Thus, reliance on PPP to derive a
forecast of the exchange rate is subject to significant error,
11
even
permitted in when applied toproduct
with a certain long-term forecasts.
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 Exhibit 8.3 Comparison of Annual Inflation Differentials and
Exchange Rate Movements for Four Major Countries

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 Purchasing Power Parity (PPP) (8 of 10)

Testing the Purchasing Power Parity Theory (cont.)

 Limitation of PPP Tests
 Results vary with the base period used. The base period
chosen should reflect an equilibrium position since
subsequent periods are evaluated in comparison to it. If a
base period is used when the foreign currency was
relatively weak for reasons other than high inflation, most
subsequent periods could show higher appreciation of that
currency than what would be predicted by PPP.

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 Purchasing Power Parity (PPP) (9 of 10)

Why Purchasing Power Parity Does Not Hold

 Confounding effects
 A change in a country’s spot rate is driven by more than the
inflation differential between two countries:

Since the exchange rate movement is not driven solely by ΔINF,

the relationship between the inflation differential and exchange
rate movement cannot be as simple as the PPP theory suggests.
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 Purchasing Power Parity (PPP) (10 of 10)

Why Purchasing Power Parity Does Not Hold

 No Substitutes for Traded Goods
 If substitute goods are not available domestically,
consumers may not stop buying imported goods.

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 International Fisher Effect (IFE) (1 of 8)

Fisher effect
 Suggests that the nominal interest rate contain
two components:
 Expected inflation rate
 Real interest rate
 The real rate of interest represents the return on
the investment to savers after accounting for
expected inflation.

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 International Fisher Effect (IFE) (2 of 8)

Using the IFE to Predict Exchange Rate Movements

 Apply the Fisher Effect to Derive Expected Inflation per
Country
 The first step is to derive the expected inflation rates of the
two countries based on the Fisher effect. The Fisher effect
suggests that nominal interest rates of two countries differ
because of the difference in expected inflation between the
two countries.
 Rely on PPP to Estimate the Exchange Rate Movement
 The second step of the international Fisher effect is to
apply the theory of PPP to determine how the exchange
rate would change in response to those expected inflation
rates of the two countries.

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 International Fisher Effect (IFE) (3 of 8)

Implications of the International Fisher Effect

 The international Fisher effect (IFE) theory suggests that
currencies with high interest rates will have high expected
inflation (due to the Fisher effect) and the relatively high
inflation will cause the currencies to depreciate (due to the
PPP effect).
 Implications of the IFE for Foreign Investors
 The implications are similar for foreign investors who attempt
to capitalize on relatively high U.S. interest rates. The foreign
investors will be adversely affected by the effects of a
relatively high U.S. inflation rate if they try to capitalize on the
high U.S. interest rates.
 Implications of the IFE for Two Non-U.S.
Currencies
 The IFE theory can be applied to any exchange rate, even
18 exchange ratesAll Rights
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involve two
May not be copied,non-U.S. currencies.
scanned, or duplicated, (Exhibit
in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 8.4 Summary of Application of the International Fisher
Effect from to Three Different Investment Scenarios

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 International Fisher Effect (IFE) (4 of 8)

Derivation of the International Fisher Effect

 Relationship between the interest rate (i)
differential between two countries and expected
exchange rate (e)
1  ih
ef  1
1 i f

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 International Fisher Effect (IFE) (5 of 8)

Derivation of the International Fisher Effect (cont.)

 Numerical example based on derivation of the IFE
Assume that the interest rate on a one-year insured home country bank
deposit is 11%, and the interest rate on a 1-year insured foreign bank
deposit is 12%. For the actual returns of these two investments to be
similar from the perspective of investors in the home country, the foreign
currency would have to change over the investment horizon by the
following percentage:
1  ih
ef  1
1 i f
1  .11
ef  1
1  .12
e f  .0089, or - .89%

Summarized in Exhibit 8.5

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 Exhibit 8.5 Summary of International Fisher Effect

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 International Fisher Effect (IFE) (6 of 8)

Derivation of the International Fisher Effect (cont.)

 Simplified relationship

e f  ih  i f

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 International Fisher Effect (IFE) (7 of 8)

Graphic Analysis of the International Fisher Effect

 Point E in Exhibit 8.6 reflects a situation where the foreign
interest rate exceeds the home interest rate by three
percentage points. The foreign currency has depreciated
by 3% to offset its interest rate advantage.
 Point F represents a home interest rate 2% above the
foreign interest rate. IFE theory suggests that the currency
should appreciate by 2% to offset the interest rate
disadvantage.
 Point F illustrates the IFE from a foreign investor’s
perspective. The home interest rate will appear attractive to
the foreign investor. However, IFE theory suggests that the
foreign currency will appreciate by 2%.
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 International Fisher Effect (IFE) (8 of 8)

Graphic Analysis of the International Fisher Effect

(cont.)
 Points on the IFE Line
 All the points along the IFE line reflect exchange rate
adjustments to offset the differential in interest rates. This
means investors will end up achieving the same yield
(adjusted for exchange rate fluctuations) whether they invest
at home or in a foreign country.
 Points below the IFE Line
 Points below the IFE line generally reflect the higher returns
from investing in foreign deposits.
 Points above the IFE Line
 Points above the IFE line generally reflect returns from
foreign deposits that are lower than the returns possible
domestically.
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 Tests of the International Fisher Effect

What Can be Tested (Exhibit 8.6)

 If the actual points (one for each period) of interest
rates and exchange rate changes were plotted over
time on a graph, we could determine whether:
 the points are systematically below the IFE line
(suggesting higher returns from foreign investing),
 above the line (suggesting lower returns from foreign
investing), or
 evenly scattered on both sides (suggesting a balance of
higher returns from foreign investing in some periods
and lower foreign returns in other periods).
 Statistical Test of the IFE
 Apply regression analysis to historical exchange rates
and the nominal interest rate differential.

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 Exhibit 8.6 Illustration of IFE Line(When Exchange Rate
Changes Perfectly Offset Interest Rate Differentials)

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 Tests of the International Fisher Effect (1 of 2)

Limitations of the IFE

 The IFE theory relies on the Fisher effect and PPP
 Limitation of the Fisher Effect
 The difference between the nominal interest rate and actual
inflation rate is not consistent. Thus, while the Fisher effect
can effectively use nominal interest rates to estimate the
market’s expected inflation over a particular period, the
market may be wrong.
 Limitation of PPP
 Other country characteristics besides inflation (income levels,
government controls) can affect exchange rate movements.
Even if the expected inflation derived from the Fisher effect
properly reflects the actual inflation rate over the period,
relying solely on inflation to forecast the future exchange rate
is subject to error.
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 Tests of the International Fisher Effect (2 of 2)

IFE Theory versus Reality

 The IFE theory contradicts how a country with a high
interest rate can attract more capital flows and therefore
cause the local currency’s value to strengthen (Ch. 4).
 IFE theory also contradicts how central banks may
purposely try to raise interest rates in order to attract
funds and strengthen the value of their local currencies
(Ch. 6).
 Whether the IFE holds in reality is dependent on the
countries involved and the period assessed.
 The IFE theory may be especially meaningful to
situations in which the MNCs and large investors
consider investing in countries where the prevailing
interest rates are very high.
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 Comparison of the IRP, PPP, and IFE

Although all three theories relate to the determination of

exchange rates, they have different implications.
(Exhibit 8.7)
 IRP focuses on why the forward rate differs from the spot
rate and on the degree of difference that should exist. It
relates to a specific point in time.
 PPP and IFE focus on how a currency’s spot rate will
change over time.
 Whereas PPP suggests that the spot rate will change in
accordance with inflation differentials, IFE suggests that
it will change in accordance with interest rate
differentials.
 PPP is related to IFE because expected inflation
differentials influence the nominal interest rate
differentials between two countries.
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 Exhibit 8.7 Comparison of the IRP, PPP, and IFE Theories

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 SUMMARY (1 of 2)

 Purchasing power parity (PPP) theory specifies a

precise relationship between the relative inflation
rates of two countries and their exchange rate. PPP
theory suggests that the equilibrium exchange rate
will adjust by about the same magnitude as the
difference between the two countries’ inflation rates.
While there is evidence of significant real world
deviations from the theory, PPP offers a logical
explanation for why currencies of countries with high
inflation tend to weaken over time.

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 SUMMARY (2 of 2)

 The international Fisher effect (IFE) specifies a precise

relationship between relative interest rates of two countries
and their exchange rates. It suggests that an investor who
periodically invests in interest-bearing foreign securities will,
on average, achieve a return similar to what is possible
domestically. This implies that the exchange rate of the
country with high interest rates will depreciate to offset the
interest rate advantage achieved by foreign investments. Yet
there is evidence that the IFE does not hold during all periods,
which means that investment in foreign short-term securities
may achieve a higher return than what is possible
domestically. However, a firm that attempts to achieve this
higher return also incurs the risk that the currency
denominating the foreign security depreciates against the
investor’s home currency during the investment period. In that
case, the foreign security would generate a lower return than
a domestic security even though it exhibits a higher interest
33 rate.
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