2. 8 - 2
Chapter Objectives
To explain the purchasing power parity
(PPP) and international Fisher effect (IFE)
theories, and their implications for
exchange rate changes; and
To compare the PPP, IFE, and interest rate
parity (IRP) theories.
3. 8 - 3
Purchasing Power Parity (PPP)
• When a country’s inflation rate rises
relative to that of another country,
decreased exports and increased imports
depress the high-inflation country’s
currency.
• Purchasing power parity (PPP) theory
attempts to quantify this inflation –
exchange rate relationship.
4. 8 - 4
Interpretations of PPP
• The absolute form of PPP is an extension
of the law of one price. It suggests that the
prices of the same products in different
countries should be equal when measured
in a common currency.
• The relative form of PPP accounts for
market imperfections like transportation
costs, tariffs, and quotas. It states that the
rate of price changes should be similar.
5. 8 - 5
Rationale behind PPP Theory
Suppose U.S. inflation > U.K. inflation.
U.S. imports from U.K. and
U.S. exports to U.K.
Upward pressure is placed on the £.
This shift in consumption and the £’s
appreciation will continue until
in the U.S.: priceU.K. goods priceU.S. goods
in the U.K.: priceU.S. goods priceU.K. goods
6. 8 - 6
Derivation of PPP
Assume that PPP holds.
Over time, inflation occurs and the exchange rate
adjusts to maintain PPP:
Ph Ph (1 + Ih )
where Ph = home country’s price index
Ih = home country’s inflation rate
Pf Pf (1 + If )(1 + ef )
where Pf = foreign country’s price index
If = foreign country’s inflation rate
ef = foreign currency’s % in value
7. 8 - 7
Derivation of PPP
Ih > If ef > 0 i.e. foreign currency appreciates
Ih < If ef < 0 i.e. foreign currency depreciates
Example: Suppose IU.S. = 9% and IU.K. = 5% .
Then eU.K. = (1 + .09 ) – 1 = 3.81%
(1 + .05 )
PPP holds Ph = Pf and
Ph (1 + Ih ) = Pf (1 + If ) (1 + ef )
Solving for ef : ef = (1 + Ih ) – 1
(1 + If )
8. 8 - 8
Simplified PPP Relationship
When the inflation differential is small, the
PPP relationship can be simplified as
ef Ih – If
Example: Suppose IU.S. = 9% and IU.K. = 5% .
Then eU.K. 9 – 5 = 4%
U.S. consumers:PU.S.
= IU.S. = 9%
PU.K.
= IU.K. + eU.K. = 9%
U.K. consumers: PU.K.
= IU.K. = 5%
PU.S.
= IU.S. – eU.K. = 5%
9. 8 - 9
Graphic Analysis of Purchasing Power Parity
PPP line
Inflation Rate Differential (%)
home inflation rate – foreign inflation rate
% in the
foreign
currency’s
spot rate
-2
-4
2
4
1 3
-1
-3
Increased
purchasing
power of
foreign
goods
Decreased
purchasing
power of
foreign
goods
A’
B’
A
B
10. 8 - 10
Why PPP Does Not Occur
PPP does not occur consistently due to:
confounding effects
¤ Exchange rates are also affected by
differences in inflation, interest rates,
income levels, government controls and
expectations of future rates.
a lack of substitutes for some traded
goods
11. 8 - 11
International Fisher Effect (IFE)
• According to the Fisher effect, nominal
risk-free interest rates contain a real rate of
return and anticipated inflation.
• If all investors require the same real return,
differentials in interest rates may be due to
differentials in expected inflation.
• Recall that PPP theory suggests that
exchange rate movements are caused by
inflation rate differentials.
12. 8 - 12
International Fisher Effect (IFE)
• The international Fisher effect (IFE) theory
suggests that currencies with higher
interest rates will depreciate because the
higher nominal rates reflect higher
expected inflation.
• Hence, investors hoping to capitalize on a
higher foreign interest rate should earn a
return no higher than what they would
have earned domestically.
13. 8 - 13
• According to the IFE, E(rf ), the expected
effective return on a foreign money market
investment, should equal rh , the effective
return on a domestic investment.
• rf = (1 + if )(1 + ef ) – 1
if = interest rate in the foreign country
ef = % change in the foreign currency’s
value
• rh =ih = interest rate in the home country
Derivation of the IFE
14. 8 - 14
• Setting rf = rh : (1 + if )(1 + ef ) – 1 = ih
• Solving for ef : ef =
(1 + ih ) _ 1
(1 + if )
Derivation of the IFE
• ih > if ef > 0 i.e. foreign currency appreciates ih < if ef
< 0 i.e. foreign currency depreciates
Example: Suppose iU.S. =11% and iU.K. =12%.
Then eU.K. = (1 + .11 ) – 1 = –.89% .
(1 + .12 )
This will make rf = rh .
15. 8 - 15
• When the interest rate differential is small,
the IFE relationship can be simplified as
ef ih
_
if
Derivation of the IFE
• If the British rate on 6-month deposits
were 2% above the U.S. interest rate, the £
should depreciate by approximately 2%
over 6 months. Then U.S. investors would
earn about the same return on British
deposits as they would on U.S. deposits.
16. 8 - 16
Graphic Analysis of the International Fisher Effect
IFE line
Interest Rate Differential (%)
home interest rate – foreign interest rate
% in the
foreign
currency’s
spot rate
-2
-4
2
4
1 3
-1
-3
Lower
returns from
investing in
foreign
deposits
Higher
returns from
investing in
foreign
deposits
A
B
C
D
17. 8 - 17
Why the IFE Does Not Occur
• Since the IFE is based on PPP, it will not
hold when PPP does not hold.
• In particular, if there are factors other than
inflation that affect exchange rates,
exchange rates may not adjust in
accordance with the inflation differential.
18. 8 - 18
Comparison of the IRP, PPP, and IFE Theories
Spot Rate
Expectations
Inflation Rate
Differential
Forward Rate
Discount or Premium
Interest Rate
Differential
Purchasing
Power Parity (PPP)
Interest Rate Parity
(IRP)
Fisher
Effect
International
Fisher Effect (IFE)
Forward
rate
as
Unbiased
Predictor
19. 8 - 19
Comparison of the IRP, PPP, and IFE Theories
Interest rate parity
Forward rate premium p
Interest rate differential ih – if
f
h
f
h
i
i
i
i
p
1
1
1
Purchasing power parity
% in spot exchange rate ef
Inflation rate differential Ih – If
f
h
f
h
f I
I
I
I
e
1
1
1
International Fisher effect
% in spot exchange rate ef
Interest rate differential ih – if
f
h
f
h
f i
i
i
i
e
1
1
1
