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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
Does Purchasing Power Parity Exist?
International Fisher Effect (IFE)
Deriving a Country’s Inflation Rate
Estimating the Expected Exchange Rate Movement
Implications of the International Fisher Effect
Derivation of the International Fisher Effect
Graphic Analysis of the International Fisher Effect
Testing the International Fisher Effect
Limitations of the IFE Theory
Comparison of IRP, PPP, and IFE Theories
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.
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).
