Chapter 8
Inflation, Interest Rates, and Exchange Rates
Lecture Outline
Purchasing Power Parity (PPP)
Interpretations of PPP
Rationale Behind PPP Theory
International Fisher Effect (IFE)
Implications of the IFE for Foreign Investors
Comparison of IRP, PPP, and IFE
2 Inflation, Interest Rates, and Exchange Rates
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
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.
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
COUNTER-POINT: No. Even if the relationship between inflation and exchange rate effects is
Inflation, Interest Rates, and Exchange Rates 3
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,
Answers to End of Chapter Questions
1. PPP. Explain the theory of purchasing power parity (PPP). Based on this theory, what is a general
forecast of the values of currencies in countries with high inflation?
ANSWER: PPP suggests that the purchasing power of a consumer will be similar when purchasing
2. Rationale of PPP. Explain the rationale of the PPP theory.
ANSWER: When inflation is high in a particular country, foreign demand for goods in that country
3. Testing PPP. Explain how you could determine whether PPP exists. Describe a limitation in testing
whether PPP holds.
ANSWER: One method is to choose two countries and compare the inflation differential to the
4 Inflation, Interest Rates, and Exchange Rates
4. Testing PPP. Inflation differentials between the U.S. and other industrialized countries have
typically been a few percentage points in any given year. Yet, in many years annual exchange rates
between the corresponding currencies have changed by 10 percent or more. What does this
information suggest about PPP?
ANSWER: The information suggests that there are other factors besides inflation differentials that
5. Limitations of PPP. Explain why PPP does not hold.
ANSWER: PPP does not consistently hold because there are other factors besides inflation that
6. Implications of IFE. Explain the international Fisher effect (IFE). What is the rationale for the
existence of the IFE? What are the implications of the IFE for firms with excess cash that consis–
tently invest in foreign Treasury bills? Explain why the IFE may not hold.
ANSWER: The IFE suggests that a currency’s value will adjust in accordance with the differential
7. Implications of IFE. Assume U.S. interest rates are generally above foreign interest rates. What
does this suggest about the future strength or weakness of the dollar based on the IFE? Should U.S.
investors invest in foreign securities if they believe in the IFE? Should foreign investors invest in
U.S. securities if they believe in the IFE?
ANSWER: The IFE would suggest that the U.S. dollar will depreciate over time if U.S. interest rates
Inflation, Interest Rates, and Exchange Rates 5
8. Comparing Parity Theories. Compare and contrast interest rate parity (discussed in the previous
chapter), purchasing power parity (PPP), and the international Fisher effect (IFE).
ANSWER: Interest rate parity can be evaluated using data at any one point in time to determine the
9. Real Interest Rate. One assumption made in developing the IFE is that all investors in all countries
have the same real interest rate. What does this mean?
ANSWER: The real return is the nominal return minus the inflation rate. If all investors require the
10. Interpreting Inflationary Expectations. If investors in the United States and Canada require the
same real interest rate, and the nominal rate of interest is 2 percent higher in Canada, what does this
imply about expectations of U.S. inflation and Canadian inflation? What do these inflationary
expectations suggest about future exchange rates?
ANSWER: Expected inflation in Canada is 2 percent above expected inflation in the U.S. If these
11. PPP Applied to the Euro. Assume that several European countries that use the euro as their
currency experience higher inflation than the United States, while two other European countries that
use the euro as their currency experience lower inflation than the United States. According to PPP,
how will the euro’s value against the dollar be affected?
ANSWER: The high European inflation overall would reduce the U.S. demand for European
12. Source of Weak Currencies. Currencies of some Latin American countries, such as Brazil and
Venezuela, frequently weaken against most other currencies. What concept in this chapter explains
this occurrence? Why don’t all U.S.-based MNCs use forward contracts to hedge their future
remittances of funds from Latin American countries to the U.S. even if they expect depreciation of
the currencies against the dollar?
6 Inflation, Interest Rates, and Exchange Rates
ANSWER: Latin American countries typically have very high inflation, as much as 200 percent or
13. PPP. Japan has typically had lower inflation than the United States. How would one expect this to
affect the Japanese yen’s value? Why does this expected relationship not always occur?
ANSWER: Japan’s low inflation should place upward pressure on the yen’s value. Yet, other
14. IFE. Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United
States is 8 percent for one-year securities that are free from default risk. What does the IFE suggest
about the differential in expected inflation in these two countries? Using this information and the
PPP theory, describe the expected nominal return to U.S. investors who invest in Mexico.
ANSWER: If investors from the U.S. and Mexico required the same real (inflation-adjusted) return,
the inexact formula, since the concept is stressed here more than precision.)
15. IFE. Shouldn’t the IFE discourage investors from attempting to capitalize on higher foreign interest
rates? Why do some investors continue to invest overseas, even when they have no other
transactions overseas?
ANSWER: According to the IFE, higher foreign interest rates should not attract investors because
Inflation, Interest Rates, and Exchange Rates 7
16. Changes in Inflation. Assume that the inflation rate in Brazil is expected to increase substantially.
How will this affect Brazil’s nominal interest rates and the value of its currency (called the real)? If
the IFE holds, how will the nominal return to U.S. investors who invest in Brazil be affected by the
higher inflation in Brazil? Explain.
ANSWER: Brazil’s nominal interest rate would likely increase to maintain the real return required
17. Comparing PPP and IFE. How is it possible for PPP to hold if the IFE does not?
ANSWER: For the IFE to hold, the following conditions are necessary:
18. Estimating Depreciation Due to PPP. Assume that the spot exchange rate of the British pound is
$1.73. How will this spot rate adjust according to PPP if the United Kingdom experiences an
inflation rate of 7 percent while the United States experiences an inflation rate of 2 percent?
19. Forecasting the Future Spot Rate Based on IFE. Assume that the spot exchange rate of the
Singapore dollar is $.70. The one-year interest rate is 11 percent in the United States and 7 percent
in Singapore. What will the spot rate be in one year according to the IFE? What is the force that
causes the spot rate to change according to the IFE?
20. Deriving Forecasts of the Future Spot Rate. As of today, assume the following information is
available:
U.S. Mexico
Real rate of interest required
by investors 2% 2%
Nominal interest rate 11% 15%
Spot rate — $.20
One-year forward rate — $.19
8 Inflation, Interest Rates, and Exchange Rates
a. Use the forward rate to forecast the percentage change in the Mexican peso over the next year.
b. Use the differential in expected inflation to forecast the percentage change in the Mexican peso
over the next year.
the peso.
c. Use the spot rate to forecast the percentage change in the Mexican peso over the next year.
21. Inflation and Interest Rate Effects. The opening of Russia’s market has resulted in a highly volatile
Russian currency (the ruble). Russia’s inflation has commonly exceeded 20 percent per month.
Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual
inflation rate in Russia.
a. Explain why the high Russian inflation has put severe pressure on the value of the Russian ruble.
ANSWER: As Russian prices were increasing, the purchasing power of Russian consumers was
b. Does the effect of Russian inflation on the decline in the ruble’s value support the PPP theory?
How might the relationship be distorted by political conditions in Russia?
ANSWER: The general relationship suggested by PPP is supported, but the ruble’s value will
c. Does it appear that the prices of Russian goods will be equal to the prices of U.S. goods from the
perspective of Russian consumers (after considering exchange rates)? Explain.
ANSWER: Russian prices might be higher than U.S. prices, even after considering exchange
d. Will the effects of the high Russian inflation and the decline in the ruble offset each other for
U.S. importers? That is, how will U.S. importers of Russian goods be affected by the
conditions?
Inflation, Interest Rates, and Exchange Rates 9
ANSWER: U.S. importers will likely experience higher prices, because the Russian inflation may
22. IFE Application to Asian Crisis. Before the Asian crisis, many investors attempted to capitalize on
the high interest rates prevailing in the Southeast Asian countries although the level of interest rates
primarily reflected expectations of inflation. Explain why investors behaved in this manner.
Why does the IFE suggest that the Southeast Asian countries would not have attracted foreign
investment before the Asian crisis despite the high interest rates prevailing in those countries?
ANSWER: The investors’ behavior suggests that they did not expect the international Fisher effect
23. IFE Applied to the Euro. Given the recent conversion of several European currencies to the euro,
explain what would cause the euro’s value to change against the dollar according to the IFE.
ANSWER: If interest rates change in these European countries whose home currency is the euro, the
Advanced Questions
24. IFE. Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-year
interest rates in Europe are 5 percent, while one-year interest rates in the U.S. are 3 percent. Beth
converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back
to dollars. The current spot rate of the euro is $1.10.
a. According to the IFE, what should the spot rate of the euro in one year be?
b. If the spot rate of the euro in one year is $1.00, what is Beth’s percentage return from her
strategy?
c. If the spot rate of the euro in one year is $1.08, what is Beth’s percentage return from her
strategy?
d. What must the spot rate of the euro be in one year for Beth’s strategy to be successful?
10 Inflation, Interest Rates, and Exchange Rates
ANSWER:
a.
1
)1(
)1(
f
h
fi
i
e
25. Integrating IRP and IFE. Assume the following information is available for the U.S. and Europe:
U.S.
Europe
Nominal interest rate
4%
6%
Expected inflation
2%
5%
Spot rate
—–
$1.13
One-year forward rate
—–
$1.10
a. Does IRP hold?
b. According to PPP, what is the expected spot rate of the euro in one year?
c. According to the IFE, what is the expected spot rate of the euro in one year?
d. Reconcile your answers to parts (a). and (c).
Inflation, Interest Rates, and Exchange Rates 11
ANSWER:
a.
1
)1(
)1(
f
h
i
i
p
According to PPP, the expected spot rate of the euro in one year is $1.13 × (1 – 2.86%) = $1.098.
26. IRP. The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is
2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14.
a. What is the forward rate premium?
b. What is the one-year forward rate of the peso?
c. Based on the international Fisher effect, what is the expected change in the spot rate over the next
year?
12 Inflation, Interest Rates, and Exchange Rates
d. If the spot rate changes as expected according to the IFE, what will be the spot rate in one year?
e. Compare your answers to (b) and (d) and explain the relationship.
ANSWER:
a. According to interest rate parity, the forward premium is
27. Testing the PPP. How could you use regression analysis to determine whether the relationship
specified by PPP exists on average? Specify the model, and describe how you would assess the
regression results to determine if there is a significant difference from the relationship suggested by
PPP.
ANSWER: A regression model could be applied to historical data to test PPP. The model is
specified as: