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Chapter 3 - ICF11e - ch08 - Inflation, Interest Rates, and Exchange Rates
Chapter 3 - ICF11e - ch08 - Inflation, Interest Rates, and Exchange Rates
11th Edition
by Jeff Madura
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8 Inflation, Interest Rates, and Exchange Rates
Chapter Objectives
n Explain the purchasing power parity (PPP) theory and
its implications for exchange rate changes
n Compare the PPP theory, the IFE theory, and the theory
of interest rate parity (IRP), which was introduced in
the previous chapter
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Purchasing Power Parity (PPP)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Rational Behind Relative PPP Theory
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Purchasing Power Parity
e f @ Ih - I f
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Using PPP to Estimate Exchange Rate Effects
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 8.1 Summary of Purchasing Power Parity
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Graphic Analysis of Purchasing Power Parity
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 8.2 Illustration of Purchasing Power Parity
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Purchasing Power Disparity
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Testing the Purchasing Power Parity Theory
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Testing the Purchasing Power Parity Theory (Cont.)
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Why Purchasing Power Parity Does Not Occur
1. Confounding effects
A change in a country’s spot rate is driven by more than the inflation
differential between two countries:
Since the exchange rate movement is not driven solely by ΔINF, the
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Why Purchasing Power Parity Does Not Occur
(Cont.)
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International Fisher Effect (IFE)
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Using the IFE to Predict Exchange Rate Movements
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Implications of the International Fisher Effect
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Derivation of the International Fisher Effect
1 + ih
ef = -1
1+ i f
2. Simplified relationship
e f @ ih - i f
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 8.6 Summary of International Fisher Effect
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Exhibit 8.7 Illustration of IFE Line (When Exchange Rate
Changes Perfectly Offset Interest Rate Differentials)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Graphic Analysis of the International Fisher Effect
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Graphic Analysis of the International Fisher Effect
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Limitations of the IFE
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Exhibit 8.9 Comparison of the IRP, PPP, and IFE Theories
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SUMMARY
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY (Cont.)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
35 © 2012 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.