CHAPTER 8

Relationships among Inflation,

Interest Rates, and Exchange Rates
Group members:

SP19-BAF-006 AIRA QAZI

SP19-BAF-001 ABDUL BASIT

FA20-BAF-087 AHMED ALI

 PURCHASING POWER PARITY (PPP)
Definition:
Purchasing Power Parity are the rates of currency conversion that equalize the purchasing power of different
currencies by eliminating the differences in price levels between countries.
• Purchasing Power Parity (PPP) Theory:
Purchasing power parity (PPP) theory states that exchange rates between currencies are in equilibrium when
their purchasing power is the same in each of the two countries.
 INTERPRETATIONS OF PPP

1. Absolute Form of PPP:

• Absolute PPP suggests that the exchange rate between two currencies should be such that the
prices of identical goods and services are the same when expressed in a common currency.
• This interpretation implies that any deviation from absolute PPP would create arbitrage
opportunities, as individuals could buy goods in one country and sell them in another to take
advantage of price differentials until prices equalize.
2. Relative Form of PPP:
• Relative PPP considers the changes in price levels over time and states that the exchange rate
should adjust to reflect the difference in inflation rates between two countries.
• According to this interpretation, a country with higher inflation will experience a depreciation of
its currency relative to the country with lower inflation.
 DERIVATION OF PPP
• Inflation rate of home country= Ih
• Price index of home country= Ph(1+ Ih)
• Inflation rate of foreign country= If
• Price index of foreign country= Pf(1+ If)
• Foreign price index from the home consumer’s perspective becomes= Pf(1+If)(1+ef)
• Percentage change in the foreign currency= ef
• Pf(1+If)(1+ef)= Ph(1+ Ih)

• 1+ef=Pf(1+If)/ Ph(1+ Ih)

• ef= (Pf(1+If)/ Ph(1+ Ih))-1
• If Ph= Pf (if price indexes are assumed equal) Ef= ((1+If)/ (1+ Ih))-1
 DERIVATION OF PPP CONT..
• Ih > If (exchange rate between the currencies of the two countries do not change,
then the consumer’s purchasing power is greater on foreign goods than on home
goods)
• ef is positive. This implies that the foreign currency will appreciate when the
home country’s inflation exceeds the foreign country’s inflation.
• Ih < If (exchange rate between the currencies of the two countries does not
change, then the consumer’s purchasing power is greater on home goods than on
foreign goods. In this case PPP does not exist)
• ef is negative. This implies that the foreign currency will depreciate when the
foreign country’s inflation exceeds the home country’s inflation. Using PPP to
Estimate Exchange R
 IMPLICATIONS OF PPP FOR EXCHANGE RATE
Price convergence:
CHANGES
PPP implies that over time, the prices of goods and services should converge across countries. If prices are
relatively higher in one country, it becomes more attractive for consumers to purchase goods and services from the
country with lower prices.
• This increased demand leads to an appreciation of the currency in the country with lower prices, causing
prices to rise there and prices to decrease in the country with higher prices.

Trade competitiveness:
PPP has implications for trade competitiveness. If a country's currency is overvalued relative to its purchasing power, its
goods and services become relatively more expensive in international markets, potentially reducing its competitiveness.
• Conversely, if a country's currency is undervalued, its goods and services become cheaper for foreign buyers,
enhancing its trade competitiveness.

Arbitrage opportunities:
PPP can create arbitrage opportunities for traders and investors. If prices of identical goods differ between two countries
due to exchange rate deviations from PPP, traders can exploit the price discrepancies by buying low in one country and
selling high in another.
• These arbitrage activities help to narrow the price differentials and contribute to the adjustment of exchange rates
towards PPP.
 Factors Hindering Purchasing Power
Parity(PPP)
Trade Barriers and Transportation Costs:
• Trade barriers like tariffs, quotas, and non-tariff barriers hinder the free flow of goods and
services.
• Transportation costs vary and can impact the overall cost of goods, leading to price differentials.

Non-Tradable Goods and Services:

• Non-tradable goods and services, such as housing and healthcare, face local regulations and
government intervention.
• These factors limit their responsiveness to exchange rate changes and hinder price equalization.

Productivity and Wage Differences:

• Productivity disparities between countries lead to differences in wages and production costs.
• Higher wages in one country can result in higher prices for domestically produced goods,
deviating from PPP.
 Factors Hindering Purchasing Power
Parity(PPP) Cont…
Market Imperfections:
• Perfect competition assumptions of PPP theory are not fully realized in
real-world markets.
• Monopolies, oligopolies, and price discrimination can distort prices
and prevent price equalization.
Government Policies and Regulations:
• Government policies, regulations, and interventions impact prices and
create deviations from PPP.
• Price controls, subsidies, and taxes influence the cost of goods and
services, hindering PPP.
 Long-Term Implications of Purchasing
Power Parity (PPP)
Real Exchange Rate and Inflation Adjustment:
• The real exchange rate is the nominal exchange rate adjusted for inflation in the two
countries.
• It reflects the relative purchasing power of currencies after considering changes in price
levels.

Testing PPP with Real Exchange Rate:

• PPP can be tested by examining the behavior of the real exchange rate over time.
• If the real exchange rate follows a random walk, it indicates that it is not constant in the
long run, suggesting a departure from PPP.
 Why PPP Does Not Occur
Purchsing Power Parity 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
 International Fisher Effect (IFE)
• International Fisher effect is a precise relation between interest rates of two
countries and their exchange rates.
• Exchange rate of country with high interest rates will depreciate to offset
the interest rate advantage achieved by foreign investments.
• Recall that PPP theory suggests that exchange rate movements are caused
by inflation rate differentials.
 International Fisher Effect (IFE)

• The international Fisher effect (IFE) theory suggests that currencies with
higher interest rates will depreciate because the higher interest 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.
SUMMARY OF IFE
Evaluating the IRP, PPP, and IFE Theories
for Exchange Rate Analysis
Interest Rate Parity Theory (IRP):
• IRP theory suggests that the difference in interest rates between two countries determines
the expected change in exchange rates.
• It states that the interest rate differential should be equal to the expected change in the
exchange rate to prevent arbitrage opportunities.

International Fisher Effect Theory (IFE):

• The International Fisher Effect (IFE) theory relates interest rates, inflation rates, and
exchange rate movements.
• It suggests that the nominal interest rate differential between two countries is equal to the
expected change in the exchange rate adjusted for the difference in inflation rates
 Evaluating the IRP, PPP, and IFE Theories for
Exchange Rate Analysis Cont…
Time Horizons:
• IRP: Short to medium-term focus on interest rate differentials and exchange rate
expectations.
• PPP: Long-term perspective on price equalization and exchange rate adjustments.
• IFE: Medium to long-term consideration of interest rates, inflation differentials, and
exchange rate movements

Application and Implications:

• IRP: Useful for currency traders and investors in assessing exchange rate movements.
• PPP: Relevant for policymakers, businesses, and analysts for understanding currency
valuation and international trade dynamics.
• IFE: Valuable for investors, particularly in determining the impact of inflation
differentials on exchange rates.
 Evaluating the IRP, PPP, and IFE Theories for
Exchange Rate Analysis Cont…
Conclusion: .

• The IRP, PPP, and IFE theories offer different perspectives on the
relationship between interest rates, inflation rates, and exchange rates.

• Each theory provides insights into specific aspects of international finance

and has implications for various stakeholders.
THANK YOU