QUESTIONS AND APPLICATIONS

1/.
One popular macroeconomic analysis metric to compare economic productivity
and standards of living between countries is purchasing power parity (PPP).
PPP is an economic theory that compares different countries' currencies through
a "basket of goods" approach - Currencies with higher inflation will
depreciation to attain equilibrium.
2/.
Rationale of PPP
When inflation is high in a particular country, foreign demand for goods in that
country will decrease. In addition, that country's demand for foreign goods
should increase.
3/.
The paper uses the data of exchange rate and ratio of GDP deflators of Bangladesh
and India covering the period 1971-2011 to justify the presence of Purchasing
Power Parity (PPP) between the two countries. Unit roots test has been used to
confirm the stationarity of the data. Cointegration test is used to verify the existence
of a long-run relationship between exchange rate and the relative cost of bundles.
While these two variables are not observed to be in equilibrium in the long run,
Granger causality test finds no causal relationship between the two. This
disequilibrium is further escalated due to the imposition of trade restrictions or other
conditions affecting the bilateral trade relationship. These obstacles need to be
addressed in order to ensure the stability of the exchange rate and maintain
favourable trade relationship based on PPP.
A limitation in testing PPP is that the results will vary with the base period
chosen. The base period should reflect an equilibrium position, but it is difficult
to determine when such a period exists.
4/. The information suggests about PPP that other factors besides inflation
differentials are influencing the exchange rate movements. Therefore, the
exchange rate movements are not necessarily obey to inflation differentials.
5/.
Purchasing power parity (PPP) will not be satisfied between countries when
there are transportation costs, trade barriers (e.g., tariffs), differences in prices
of nontradable inputs (e.g., rental space), imperfect information about current
market conditions, and when other Forex market participants, such as
investors, ...
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7/.
According to the IFE, the US dollar will depreciate over time if US interest
rates are currently higher than foreign interest rates. Foreign investors who
purchased US securities would, on average, receive a similar yield as they
would receive in their home country, and US investors that purchased foreign
securities, on average, receive a yield similar to US rates.
According to the IFE, the US dollar will depreciate over time if US interest
rates are
currently higher than foreign interest rates. Foreign investors who purchased US
securities
would, on average, receive a similar yield as they would receive in their home
country, and
US investors that purchased foreign securities, on average, receive a yield
similar to US
According to the IFE, the US dollar will depreciate over time if US interest
rates are
currently higher than foreign interest rates. Foreign investors who purchased US
securities
would, on average, receive a similar yield as they would receive in their home
country, and
US investors that purchased foreign securities, on average, receive a yield
similar to US
6. 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
consistently invest in foreign Treasury bills? Explain why the IFE may not hold.
The IFE suggest that a currency’s value will adjust in accordance with the
differential in
interest rates between two countries. This is based on the idea that if a particular
country has
a high nominal interest rate, there may be anticipation of high inflation. The
inflation will
place downward pressure on the currency’s value if it does rise. A firm that
consistently
purchases foreign Treasury bills will, on average, earn a similar return as on
domestic
Treasury bills. IFE may not hold because exchange rate movements are affected
by multiple
factors, therefore an exchange rate may not adjust in direct correlation to the
nominal interest
rate differentials, so IFE may not hold.
7. 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
US investors invest in foreign securities if they believe in the IFE? Should
foreign
investors invest in US securities if they believe in the IFE?
6. 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
consistently invest in foreign Treasury bills? Explain why the IFE may not hold.
The IFE suggest that a currency’s value will adjust in accordance with the
differential in
interest rates between two countries. This is based on the idea that if a particular
country has
a high nominal interest rate, there may be anticipation of high inflation. The
inflation will
place downward pressure on the currency’s value if it does rise. A firm that
consistently
purchases foreign Treasury bills will, on average, earn a similar return as on
domestic
Treasury bills. IFE may not hold because exchange rate movements are affected
by multiple
factors, therefore an exchange rate may not adjust in direct correlation to the
nominal interest
rate differentials, so IFE may not hold.
7. 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
US investors invest in foreign securities if they believe in the IFE? Should
foreign
investors invest in US securities if they believe in the IFE?
6. 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
consistently invest in foreign Treasury bills? Explain why the IFE may not hold.
The IFE suggest that a currency’s value will adjust in accordance with the
differential in
interest rates between two countries. This is based on the idea that if a particular
country has
a high nominal interest rate, there may be anticipation of high inflation. The
inflation will
place downward pressure on the currency’s value if it does rise. A firm that
consistently
purchases foreign Treasury bills will, on average, earn a similar return as on
domestic
Treasury bills. IFE may not hold because exchange rate movements are affected
by multiple
factors, therefore an exchange rate may not adjust in direct correlation to the
nominal interest
rate differentials, so IFE may not hold.
7. 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
US investors invest in foreign securities if they believe in the IFE? Should
foreign
investors invest in US securities if they believe in the IFE?
8/. Interest rate parity can be evaluated using data at any one point in time to
determine the relationship between the interest rate differential of two countries
and the forward premium (or discount). PPP suggests a relationship between the
inflation differential, and IFE suggests a relationship between the interest rate
differential, of two countries and the percentage change in the spot exchange
rate over time. IFE is closely related to PPP because IFE is based on nominal
interest rate differentials, which are influenced by expected inflation.
9/.
Real return = nominal return – inflation rate
If all investors require the same real return, the differentials in nominal interests
would be due exclusively to differentials in anticipated inflation among
countries.
10/.
Expected inflation in Canada is 2% higher than expected inflation in the US. If
these expectations were true, PPP suggests that the value of the Canadian dollar
should depreciate against the US dollar by 2%.
11/.
Overall, high European inflation would reduce US demand for European
products and increase European demand for US products, causing the euro to
depreciate against the US dollar.
12/.
Latin American countries typically have inflation has high as 200% or more.
PPP suggests that the currencies of these countries will depreciate against the
US dollar and other major currencies to retain purchasing power across
countries. High inflation lowers demand for Latin American products and
places downward pressure on Latin American currencies. The depreciation
offsets increased prices on Latin American goods in the eyes of foreign
importers.
13/.
Low inflation in Japan should place upward pressure on the yen, but other
factors can offset this pressure. An example would be Japan's large amount of
investments in US securities, which places downward pressure on the yen.
14/.
If US and Mexican investors required the same real return, any difference in
nominal interest rates would be due to differences in expected inflation. The
inflation rate in Mexico is expected to be about 40% higher than the US
inflation rate. According to PPP, the Mexican peso should depreciate by about
40%. Given a 48% nominal interest rate in Mexico and an expected
depreciation of the peso of 40%, US investors will earn about 8%.
15/.
According the IFE, investors should not be attracted to higher foreign interest
rates because these rates imply high expected inflation rates, indicating a
potential depreciation of the currency. Investors still invest in foreign countries
where nominal interest rates are high which suggests that the anticipated high
inflation is overestimated, the potentially high inflation will not cause a
substantial depreciation of the foreign currency, or there are other factors that
can offset the impact of inflation of the foreign currency's value.
16/.
Brazil's nominal interest rate would most likely increase to maintain the real
return required by Brazilian investors and the real would depreciate. If the IFE
holds, the return to US investors who invest in Brazil would not be affected.
The expected decline in the real offsets the additional interest to be earned by
the increase in the nominal interest rate.
17/.
In order for IFE to hold investors across countries must require the same real
returns, the expected inflation rate embedded in the nominal interest rate must
occur, and the exchange rate must adjust to the inflation rate differential
according to PPP. If the first or second condition does not hold, PPP may still
hold, but investors may achieve higher returns from foreign securities and IFE
would be false.
18/.
According to PPP, the exchange rate of the pound will depreciate by 4.7% and
the spot rate would adjust to 1.73 • [1+ (-0.0467)] = $1.649
19/.
(1 + 0.0374) = $0.7262 Inflation differential causes this expected effect on the
spot rate and the anticipated inflation differential can be derived from interest
rate differential.
20/.
a. Uses the forward rate to forecast the percentage change in Mexican peso over
the next year (0.19 – 0.20) /0.20 = -0.05 = 5% b. Use the differential in expected
inflation to forecast the percentage change in the Mexican peso over the next
year (1.09 / 1.13) –1 = -0.0353 = -3.53% c. Use the spot rate to forecast the
percentage change in the Mexican peso over the next year 0% change
21/.
a. Explain why the high Russian inflation typically places a severe downward
pressure on the value of the Russian ruble
As Russian prices were increasing, the purchasing power of Russian consumers
was declining. This would encourage them to purchase foreign goods, which
results in a large supply of rubles for sale. Given the high Russian inflation rate,
foreign demand for rubles to purchase Russian goods would be low, thus the
ruble's value should depreciate against the dollar and other currencies.
b. In some periods, the Russian government intervenes in the foreign exchange
market and imposes some restrictions on international trade. Why might these
conditions prevent purchasing power parity (PPP)?
The general relationship suggested by PPP is supported, but the ruble's value
will not normally move exactly as specified by PPP. The political conditions
that could restrict trade or currency convertibility can prevent Russian
consumers from shifting to foreign goods, thus the ruble may not decline by the
full degree to offset the inflation differential between Russia and the US.
Furthermore, the government may not allow the ruble to float freely to its
proper equilibrium level.
c. Will the effects of the high Russian inflation and the decline in the rube offset
each other for US importers? That is, how will US importers of Russian
products
be affected by the conditions?
US importers may experience higher prices because the inflation of Russia may
not be able to completely offset the decline of the ruble value, resulting in a
reduction in demand for US goods.
SELF-TEST
1/.
If Japanese prices rise because of inflation in that country, then the value of the
yen should decline. Thus even though the importer might need to pay more yen,
it would benefit from a weaker yen value (it would pay fewer dollars for a given
amount in yen). Thus there could be an offsetting effect if PPP holds.
2/.
Purchasing power parity does not necessarily hold. In our example, Japanese
inflation could rise (causing the importer to pay more yen), and yet the Japanese
yen would not necessarily depreciate by an offsetting amount, or at all.
Therefore, the dollar amount to be paid for Japanese supplies could increase
over time.
3/.
High inflation will cause a balance-of-trade adjustment, whereby the United
States will reduce its purchases of goods in these countries, while the demand
for U.S. goods by these countries should increase (according to PPP).
Consequently, there will be downward pressure on the values of these
currencies.