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

Flashcards covering key vocabulary and concepts related to inflation, interest rates, exchange rates, and their interrelationships.

Purchasing Power Parity (PPP)

A theory that states that in the absence of transportation costs and other barriers, identical goods should have the same price in different countries when measured in a common currency.

International Fisher Effect (IFE)

A theory that suggests that the expected change in exchange rates between two currencies is equal to the difference in their nominal interest rates.

Absolute Form of PPP

A version of PPP that argues that prices for the same goods should be the same in different countries when expressed in a common currency.

Relative Form of PPP

A version of PPP that accounts for market imperfections where prices may not be equal, but the rate of change in prices will be the same.

Inflation Differential

The difference in the inflation rates between two countries, influencing the expected changes in their exchange rates.

Real Interest Rate

The interest rate that is adjusted for inflation, representing the increase in purchasing power.

Nominal Interest Rate

The stated interest rate of a loan or investment without adjusting for inflation.

Exchange Rate

The value of one currency for the purpose of conversion to another.

Fisher Effect

The relationship between nominal interest rates, real interest rates, and the rate of inflation.

Limitations of PPP

Factors such as transportation costs, taxes, tariffs, and market imperfections may impede the accuracy of PPP.

Testing PPP

Comparing inflation differentials to the percentage change in foreign currency’s value over time to evaluate the validity of PPP.

Limitations of IFE

The IFE relies on the assumption that real interest rates are constant across countries, which may not always hold true.