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
Comparison of IRP, PPP, and IFE
Relationships Among Inflation, Interest Rates, and Exchange Rates ❖ 2
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
Topics to Stimulate Class Discussion
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,
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.
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.
Relationships Among Inflation, Interest Rates, and Exchange Rates ❖ 3
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?
2. Rationale of PPP. Explain the rationale of the PPP theory.
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
exchange rate change for several different periods. Then, determine whether the exchange rate
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?
5. Limitations of PPP. Explain why PPP does not hold.
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 in
interest rates between two countries.
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?
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).
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?
Relationships Among Inflation, Interest Rates, and Exchange Rates ❖ 5
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?
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?
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?
ANSWER: Latin American countries typically have very high inflation, as much as 200 percent or
more. PPP theory would suggest that currencies of these countries will depreciate against the U.S.
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?
Relationships Among Inflation, Interest Rates, and Exchange Rates ❖ 6
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,
then any difference in nominal interest rates is due to differences in expected inflation. Thus, the
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
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.
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:
Relationships Among Inflation, Interest Rates, and Exchange Rates ❖ 7
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
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.
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.
Relationships Among Inflation, Interest Rates, and Exchange Rates ❖ 8
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 not
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.
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?
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
(IFE) to hold. Since central banks of some Asian countries were maintaining their currencies within
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.
Relationships Among Inflation, Interest Rates, and Exchange Rates ❖ 9
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?
ANSWER:
a.
1
)1(
)1(
−
+
+
=
f
h
fi
i
e
b.
c.
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).
ANSWER:
b.
c.
Relationships Among Inflation, Interest Rates, and Exchange Rates ❖ 11
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?
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.
28. Testing the IFE. Describe a statistical test for the IFE.
ANSWER: A regression model could be applied to historical data to test IFE. The model is specified
as:
29. Impact of Barriers on PPP and IFE. Would PPP be more likely to hold between the United States
and Hungary if trade barriers were completely removed and if Hungary’s currency were allowed to
float without any government intervention? Would the IFE be more likely to hold between the United
States and Hungary if trade barriers were completely removed and if Hungary’s currency were
allowed to float without any government intervention? Explain.