Chapter 8
Relationships Among Inflation,
Interest Rates, and Exchange Rates
Lecture Outline
Purchasing Power Parity (PPP)
Interpretations of PPP
Rationale Behind PPP Theory
Derivation of PPP
Using PPP to Estimate Exchange Rate Effects
Graphic Analysis of PPP
Testing the PPP Theory
Why PPP Does Not Occur
International Fisher Effect (IFE)
Implications of the IFE for Foreign Investors
Derivation of the IFE
Graphic Analysis of the IFE
Tests of the IFE
Limitations of the IFE
Comparison of IRP, PPP, and IFE
Chapter Theme
This chapter discusses the relationship between inflation and exchange rates according to the purchasing
power parity (PPP) theory. Since this is one of the most popular subjects in international finance, it is
covered thoroughly. While PPP is a relevant theory, it should be emphasized that PPP will not always
hold in reality. However, it provides a foundation in understanding how inflation can affect exchange
rates. The international Fisher effect (IFE) is also discussed in this chapter. This theory is also very
important. Yet, it should again be emphasized that this theory does not always hold. If the PPP and IFE
theories held consistently, decision making by MNCs would be much easier. Because these theories do
not hold consistently, an MNC’s decision making is very challenging.
Topics to Stimulate Class Discussion
1. Provide reasoning for why highly inflated countries tend to have weak home currencies.
2. Identify the inflation rate of your home country and some well-known foreign country. Then identify
the percentage change of your home currency with respect to that foreign country. Did the currency
change in the direction and by the magnitude that you would have expected according to PPP? If not,
offer possible reasons for this discrepancy.
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Relationships Among Inflation, Interest Rates, and Exchange Rates 2
3. Identify the quoted one-year interest rates in your home country and in a well-known foreign country
as of one year ago. Also determine how your home currency changed relative to this foreign currency
over the last year. Did the currency change according to the IFE theory? If not, does this information
disprove IFE? Elaborate.
4. Provide a simple explanation of the difference between interest rate parity (from the previous
chapter), PPP (from this chapter), and IFE (from this chapter).
POINT/COUNTER-POINT:
Does PPP Eliminate Concerns about Long-Term Exchange Rate Risk?
POINT: Yes. Studies have shown that exchange rate movements are related to inflation differentials in the
long run. Based on PPP, the currency of a high-inflation country will depreciate against the dollar. A
subsidiary in that country should generate inflated revenue from the inflation, which will help offset the
adverse exchange effects when its earnings are remitted to the parent. If a firm is focused on long-term
performance, the deviations from PPP will offset over time. In some years, the exchange rate effects may
exceed the inflation effects, and in other years the inflation effects will exceed the exchange rate effects.
COUNTER-POINT: No. Even if the relationship between inflation and exchange rate effects is
consistent, this does not guarantee that the effects on the firm will be offsetting. A subsidiary in a
high-inflation country will not necessarily be able to adjust its price level to keep up with the increased
costs of doing business there. The effects vary with each MNC’s situation. Even if the subsidiary can raise
its prices to match the rising costs, there are short-term deviations from PPP. The investors who invest in
an MNC’s stock may be concerned about short-term deviations from PPP, because they will not
necessarily hold the stock for the long term. Thus, investors may prefer that firms manage in a manner
that reduces the volatility in their performance in short-run and long-run periods.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
ANSWER: It is possible that inflation and exchange rate effects will offset over the long run. However,
many investors will not be satisfied because they may invest in the firm for just a few years or even a
shorter term. Thus, they will prefer that MNCs assess their exposure to exchange rate risk and attempt to
limit the risk.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, 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.