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Relationships Among Inflation, Interest Rates, and Exchange Rates
Learning Objectives

  • Explain purchasing power parity (PPP) and International Fisher effect (IFE) theories regarding exchange rate changes.

Purchasing Power Parity (PPP)

  • Absolute Form: Prices of identical goods should equal in different countries when measured in a common currency.

  • Relative Form: Prices may differ due to market imperfections, but the rate of price change should align in common currency.

  • Relative PPP Theory: Exchange rates adjust to maintain purchasing power parity, prompting consumer shifts towards cheaper options.

  • Derivation: Positive correlation between inflation rates (I) and exchange rates (e), indicating that foreign currencies appreciate with lower domestic inflation and vice versa.

  • PPP Application: The relative form helps estimate exchange rate changes due to differing inflation rates.

  • Graphic Analysis: A visual representation captures expected currency adjustments based on inflation differentials.

  • Testing PPP: Involves comparing inflation rate differentials with foreign currency value changes over time.

  • Limitations: Results can vary based on the base period used for comparison.

  • Non-Validity of PPP: Influencers like interest rates and government controls can disrupt purchasing parity.

International Fisher Effect (IFE)

  • The nominal interest rate is the sum of expected inflation and the real interest rate.

  • Expected inflation rate can be derived from nominal interest rates, allowing for prediction of exchange rate movements.

  • IFE suggests currencies with higher nominal interest rates will depreciate due to expected inflation.

  • Applications indicate that different nominal interest rates in countries (e.g., Canada, US, Japan) affect expected returns and risks of depreciation for foreign investments.

  • Limitations of IFE: Variability in nominal rates and inaccurate forecasting based on inflation can lead to errors.

Comparison of Theories

  • IRP: Relates forward and spot rates based on interest differentials.

  • PPP: Connects spot rate changes to inflation differentials.

  • IFE: Links spot rate movements to nominal interest rate differentials.

Summary

  • PPP theory shows relationships between inflation and exchange rates with implications for currency depreciation. IFE theory correlates interest rates to expected exchange rates, highlighting risks in investing in foreign currencies.