C HA P T E R 8 Relationships

C HA P T E R 8 Relationships among Inflation, Interest Rates, and Exchange Rates

Chapter Overview A. Purchasing Power Parity (PPP) B. International Fisher Effect (IFE) C. Comparison of the IRP, PPP, IFE Theories and

Chapter 8 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 theory of interest rate parity (IRP), which was introduced in the previous chapter

A. Purchasing Power Parity (PPP) 1. Interpretations of Purchasing Power Parity a. Absolute Form of PPP b. Relative Form of PPP 2. Rationale behind Purchasing Power Parity Theory 3. Derivation of Purchasing Power Parity

A. Purchasing Power Parity (PPP) 4. Using PPP to Estimate Exchange Rate Effects a. Using a Simplified PPP Relationship 5. Graphic Analysis of Purchasing Power Parity a. PPP Line b. Purchasing Power Disparity

Illustration of Purchasing Power Parity 8. 1

A. Purchasing Power Parity (PPP) 6. Testing the Purchasing Power Parity Theory a. Conceptual Tests of PPP United country) 1. ) choose two countries (say, the States and a foreign 2. ) compare the differential in their inflation rates to the percentage change in the foreign currency’s value during several time periods.

Identifying Disparity in Purchasing Power 8. 2

A. Purchasing Power Parity (PPP) b. Statistical Test of PPP c. Results of Tests of PPP d. Tests of PPP for Each Currency e. Limitations of PPP Tests

Comparison of Annual Inflation Differentials and Exchange Rate Movements For Four Major Currencies 8. 3

A. Purchasing Power Parity (PPP) 7. Why Purchasing Power Parity Does Not Occur a. Confounding Effects b. No Substitutes for Traded Goods

A. Purchasing Power Parity (PPP) 8. Purchasing Power Parity in the Long Run Abuaf and Jorion: 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) 1. Relationship with Purchasing Power Parity 2. Implications of the IFE for Foreign Investors

B. International Fisher Effect (IFE) 3. Derivation of the International Fisher Effect a. Numerical Example based on the Derivation of IFE b. Simplified Relationship

B. International Fisher Effect (IFE) 4. Graphic Analysis of the International Fisher Effect a. Points on the IFE Line b. Points below the IFE Line c. Points above the IFE Line

Illustration of IFE Line (When Exchange Rate Changes Perfectly Offset Interest Rates Differentials) 8. 5

B. International Fisher Effect (IFE) 5. Test of the International Fisher Effect a. Results from testing the IFE b. Statistical Test of the IFE

B. International Fisher Effect (IFE) 6. Why the international Fisher Effect Does Not Occur a. PPP does not hold in certain times b. Since IFE based on PPP, it does not hold consistently either

C. Comparison of the IRP, PPP, and IFE Theories 8. 7