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Chapter 8 Inflation, interest rate and exchange rate PPP, Fisher
Finance (FIN300)
Đại học Kinh tế Quốc dân
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8
Relationships among Inflation,
InterestRates,andExchangeRates
Inflation rates and interest rates can have a significant impact on exchange
rates (as explained in Chapter 4) and therefore can influence the value of
MNCs. Financial managers of MNCs must understand how inflation and
interest rates can affect exchange rates so that they can anticipate how
their MNCs may be affected.
8-1 Purchasing Power Parity (PPP)
In Chapter 4, the expected impact of relative inflation rates on exchange rates was discussed. Recall from this discussion that when a country’s inflation rate rises, the demand for its cur- rency declines as its exports decline (because of their higher prices). In addition, consumers and firms in that country tend to increase their importing. Both of these forces place down- ward pressure on the high-inflation country’s currency. Inflation rates often vary among coun- tries, causing international trade patterns and exchange rates to adjust accordingly. One of the most popular and controversial theories in international finance is thepurchasing power parity (PPP) theory, which attempts to quantify the relationship between inflation and the exchange rate. This theory supports the notion developed inChapter 4 about how relatively high inflation places downward pressure on a currency’s value, but PPP is more specific about the degree by which a currency will weaken in response to high inflation.
8-1a Interpretations of Purchasing Power Parity
There are two popular forms of PPP theory, each with its own implications.
Absolute Form of PPP Theabsolute form of PPPis based on the idea that, in the
absence of international barriers, consumers will shift their demand to wherever prices are lowest. The implication is that prices of the same basket of products in two different countries should be equal when measured in a common currency. If there is a discrep- ancy in the prices as measured by such a common currency, then demand should shift so that these prices converge.
EXAMPLE If the same basket of products is produced by the United States and the United Kingdom and if the price in the United Kingdom is lower when measured in a common currency, then the demand for that basket should increase in the United Kingdom and decline in the United States. Both forces would eventually cause the prices of the baskets to match when measured in a common currency The existence of transportation costs, tariffs, and quotas renders the absolute form of PPP unrealistic. If transportation costs were high in the preceding example, then demand
CHAPTER
OBJECTIVES
The specific objectives of this chapter are to:
■explain the purchasing power parity (PPP) theory and its implications for exchange rate changes, and ■explain the international Fisher effect (IFE) theory and its implications for exchange rate changes.
for the baskets of products might not shift as suggested. In that case, the discrepancy in prices would continue.
Relative Form of PPP Therelative form of PPPaccounts for such market
imperfections as transportation costs, tariffs, and quotas. This version acknowledges that these imperfections make it unlikely for prices of the same basket of products in different countries to be the same when measured in a common currency. However, this form of PPP suggests that therate of changein the prices of those baskets should be comparable when measured in a common currency (assuming that transportation costs and trade barriers are unchanged).
EXAMPLE Assume that the United States and the United Kingdom trade extensively with each other and initially have zero inflation. Now suppose that the United States experiences a 9 percent inflation rate while the United Kingdom experiences a 5 percent inflation rate. Under these conditions, PPP theory suggests that the British pound should appreciate by approximately 4 percent (the difference between their inflation rates). Given British inflation of 5 percent and the pound’s appreciation of 4 percent, U. consumers will have to pay about 9 percent more for British products than they paid in the initial equilibrium state. That value is equal to the 9 percent increase in prices of U. products due to U. inflation. The exchange rate should adjust to offset the differential in the two countries’inflation rates, in which case the prices of pro- ducts in the two countries should appear similar to consumers
8-1b Rationale behind Relative PPP Theory
The relative PPP theory is based on the notion that exchange rate adjustment is neces- sary for the relative purchasing power to be the same whether buying products locally or from another country. If that purchasing power is not equal, then consumers will shift purchases to wherever products are cheaper until purchasing power equalizes.
EXAMPLE Reconsider the previous example but now suppose that the pound appreciated by only 1 percent in response to the inflation differential. In this case, the increased price of British products to U. consumers will be approximately 6 percent (5 percent inflation and 1 percent appreciation in the British pound), which is less than the 9 percent increase in the price of U. products to U. consumers. We should there- fore expect U. consumers to continue shifting their consumption to British products. Purchasing power parity suggests that this increased U. consumption of British products by U. consumers would persist until the pound appreciated by about 4 percent. Thus, from the U. consumer’s viewpoint, any level of appreciation lower than this would result in lower British prices than U. prices. From the British consumer’s viewpoint, the price of U. products would have initially increased by 4 percent more than British products. Thus British consumers would continue to reduce their imports from the United States until the pound appreciated enough to make U. products no more expensive than British products. The net effect of the pound appreciating by 4 percent is that the prices of U. pro- ducts would increase by approximately 5 percent to British consumers (9 percent inflation minus the 4 percent savings to British consumers due to the pound’s 4 percent appreciation).l
8-1c Derivation of Purchasing Power Parity
Assume that the price indexes of the home country (h) and a foreign country (f) are equal. Now assume that, over time, the home country experiences an inflation rate ofIh while the foreign country experiences an inflation rate ofIf. Because of this inflation, the price index of products in the consumer’s home country (Ph) becomes
Phð 1 þIhÞ
The price index of the foreign country (Pf) will also change in response to inflation in that country:
258 Part 2:Exchange Rate Behavior
According to this example, the foreign currency should appreciate by 1 percent in response to the higher inflation of the home country relative to the foreign country. If that exchange rate change does occur, then the price index of the foreign country will be as high as the index in the home country from the perspective of home country consu- mers. The lower relative inflation in the foreign country causes appreciation of its currency (according to PPP), which pushes the foreign price index upward from the perspective of home country consumers. When considering the exchange rate effect, price indexes of both countries rise by 5 percent from the home country perspective. Thus consumers’pur- chasing power is the same for foreign products and home products.
EXAMPLE This example examines the case where foreign inflation exceeds home inflation. Suppose that the exchange rate is initially in equilibrium but then the home country experiences a 4 percent inflation rate while the foreign country experiences a 7 percent inflation rate. According to PPP, the foreign currency will adjust as follows:
ef¼ 1 þIh 1 þIf 1
¼ 1 þ: 04 1 þ: 07 1 ¼: 028 , or 2 :8% According to this example, the foreign currency should depreciate by 2 percent in response to the foreign country’s higher inflation relative to that of the home country. The higher relative inflation in the foreign country causes depreciation of its currency (according to PPP) and pushes the foreign price index downward from the perspective of home country consumers. When considering the exchange rate impact, prices of both countries rise by 4 percent. Thus PPP still holds in view of the adjustment in the exchange rate The theory of purchasing power parity is summarized in Exhibit 8. Notice that international trade is the mechanism by which the inflation differential is theorized to affect the exchange rate. This means that PPP is more applicable when the two countries of concern engage in extensive international trade with each other. If there is not much trade between the countries, then the inflation differential will have little effect on that trade and so the exchange rate should not be expected to change.
Using a Simplified PPP Relationship A simplified but less precise relationship
based on PPP is
efIhIf
That is, the percentage change in the exchange rate should beapproximately equal to the difference in inflation rates between the two countries. This simplified formula is appropri- ate only when the inflation differential is small or when thevalue ofIfis close to zero.
8-1e Graphic Analysis of Purchasing Power Parity
Using PPP theory, we should be able to assess the possible impact of inflation on exchange rates. Exhibit 8 is a graphic representation of PPP theory. The points on the graph indicate that, if there is an inflation differential ofXpercent between the home and the foreign country, then the foreign currency should adjust by X percent in response to that inflation differential.
PPP Line The diagonal line connecting all these points together is known as the
purchasing power parity (PPP) line. Point A in Exhibit 8 represents our earlier example in which the U. (considered the home country) and British inflation rates were assumed to be 9 and 5 percent (respectively), so thatIhIf¼4%. Recall that these conditions led
260 Part 2:Exchange Rate Behavior
to the anticipated appreciation in the British pound of 4 percent, as illustrated by point A. Point B reflects the scenario in which the U. inflation rate exceeds the U. inflation rate by 5 percent, so thatIhIf¼5%. This leads the British pound to depreciate by 5 per- cent (point B). If the exchange rate does in fact respond to inflation differentials, as PPP theory suggests, then the actual points should lie on or close to the PPP line.
PPP Line The diagonal line connecting all these points together is known as thepur-
chasing power parity (PPP) line. Point A in Exhibit 8 represents our earlier example in which the U. (considered the home country) and British inflation rates were assumed to be 9 and 5 percent (respectively), so thatIhIf¼4%. Recall that these conditions led to the anticipated appreciation in the British pound of 4 percent, as illustrated by point A. Point B reflects the scenario in which the U. inflation rate exceeds the U. inflation rate by 5 percent, so thatIhIf¼5%. This leads the British pound to depreciate by 5 percent (point B). If the exchange rate does in fact respond to inflation differentials, as PPP theory suggests, then the actual points should lie on or close to the PPP line.
Purchasing Power Disparity Any points that areoffof the PPP line represent
purchasing power disparity. If the exchange rate does not move as PPP theory suggests, then there is a disparity in the purchasing power of consumers in those two countries.
Exhibit 8 Summary of Purchasing Power Parity
Relatively High Local Innation
Scenario 1
Scenario 2
Scenario 3
Relatively Low Local Innation
Local and Foreign Innation Rate Are Similar
No Impact of Innation on Import or Export Volume
Local Currency’s Value Is Not Affected by Innation
Imports Will Increase; Exports Will Decrease
Imports Will Decrease; Exports Will Increase
Local Currency Should Depreciate by Same Degree as Innation Differential
Local Currency Should Appreciate by Same Degree as Innation Differential
Chapter 8:Relationships among Inflation, Interest Rates, and Exchange Rates 261
8-1f Testing the Purchasing Power Parity Theory
The PPP theory provides an explanation of how relative inflation rates between two countries can influence an exchange rate, and it also provides information that can be used to forecast exchange rates.
Simple Test of PPP A simple test of PPP theory is to choose two countries (such as
the United States and a foreign country) and compare the differential in their inflation rates to the percentage change in the foreign currency’s value during several time periods. Using a graph similar to Exhibit 8, we could plot each point representing the inflation differential and exchange rate percentage change for each specific time period and then determine whether these points closely resemble the PPP line as drawn in Exhibit 8. If the points deviate significantly from the PPP line, then the percentage change in the foreign currency is not being affected by the inflation differential in the manner that PPP theory suggests. This simple test of PPP is applied to four different currencies from a U. perspective in Exhibit 8 (each graph represents a particular currency). The annual difference in inflation between the United States and each foreign country is represented on the verti- cal axis, while the annual percentage change in the exchange rate of each foreign cur- rency (relative to the U. dollar) is represented on the horizontal axis. Each point on a graph represents one year during the period 1982–2014. Although each graph shows different results, some general comments apply to all four of them. The percentage changes in exchange rates are typically much more pronounced than the inflation differentials. The annual inflation differential between the United States and the country represented in each of the four graphs is typically small, but the annual percentage change in each currency’s exchange rate against the dollar is sometimes large. Thus exchange rates commonly change to a greater extent than PPP theory would predict. Similar results would occur for most currencies of developed countries. In some years, the currency actually appreciated when its inflation was higher than U. inflation. Overall, the results in Exhibit 8 indicate that the actual relationship between inflation differentials and exchange rate movements is not consistent with PPP theory.
Statistical Test of PPP A simplified statistical test of PPP can be developed by
applying regression analysis to historical exchange rates and inflation differentials (see Appendix C for more information on regression analysis). To illustrate, let’s focus on one particular exchange rate. The quarterly percentage changes in the foreign currency value (ef) can be regressed against the inflation differential that existed at the beginning of each quarter as follows:
ef¼a 0 þa 1
1 þIU:S:
1 þIf
1
þμ
Herea 0 is a constant,a 1 is the slope coefficient, andμis an error term. Regression anal- ysis would be applied to quarterly data to determine the regression coefficients. The hypothesized values ofa 0 anda 1 are 0 and 1, respectively. These coefficients imply that, on average, for a given inflation differential there is an equal (offsetting) percentage change in the exchange rate. The appropriate t-test for each regression coefficient requires a comparison to the hypothesized value and division by the standard error (s.) of the coefficient as follows:
Test for a 0 ¼0: Test for a 1 ¼1:
t¼
a 0 0
s:e:of a 0
t¼
a 1 1
s:e:of a 1
Chapter 8:Relationships among Inflation, Interest Rates, and Exchange Rates 263
The next step is using thet-table to find the criticalt-value. If eithert-test finds that the coefficients differ significantly from what is expected, then the relationship between the inflation differential and the exchange rate isother than as stated by PPP theory. However, there is controversy over the appropriate lag time (between the inflation differential and the exchange rate) to use when making these calculations.
Results of Statistical Tests of PPP Numerous studies have been conducted to
statistically test whether PPP holds. Although much research has documented how high inflation can weaken a currency’s value, evidence has also been found of signifi- cant deviations from PPP. These deviations are less pronounced when longer time periods are considered, but they remain nonetheless. As a result, relying on PPP to derive a forecast of the exchange rate is subject to significant error, even for long- term forecasts.
Exhibit 8 Comparison of Annual Inflation Differentials and Exchange Rate Movements for Four Major Countries
% D in Swiss Franc –20 –10–30 10 20 30
10
20
30
–20 –10–30 10 20 30
10
20
30
–20 –10–30 10 20 30
10
20
30
–20 –10–30 10 20 30
10
20
30
U. Innation Minus Canadian Innation (%) U. Innation Minus Swiss Innation (%)
U. Innation Minus British Innation (%) U. Innation Minus Japanese Innation (%)
% D in Canadian $
% D in Japanese Yen
% D in British Pound
264 Part 2:Exchange Rate Behavior
United States (where their relative purchasing power is now stronger). Yet if the U. consumers think the quality of Swiss jewelry is higher, they may not view U. jewelry as a reasonable substitute for Swiss jew- elry; thus they may continue to purchase the Swiss jewelry even though their purchasing power for Swiss jewelry is reduced. Therefore, the demand and supply conditions for the Swiss franc might not change in the manner suggested by PPP
8-2 International Fisher Effect (IFE)
According to PPP, exchange rates respond to the difference in actual inflation rates of countries over the same period. But, because the actual inflation rates are not known until the period is over, they cannot be used to anticipate how exchange rates might change. Another theory, known as theinternational Fisher effect (IFE) theory, offers a specific relationship between the differential in nominal interest rates of two coun- tries and the exchange rate movement. It suggests (1) how each country’s nominal interest rate can be used to derive its expected inflation rates, and (2) how the differ- ence in inflation rates between two countries signals an expected change in the exchange rate. These two parts are described in turn and lead to a conclusion for investors in low-interest countries who attempt to capitalize on higher interest rates in other countries.
8-2a Deriving a Country’s Expected Inflation Rate
In the 1930s, the economist Irving Fisher developed a theory (now referred to as the Fisher effect) that defines the relationship between the nominal (quoted) interest rate and the expected inflation rate. The foundation of the Fisher effect is that potential savers in a country should require that their return from a local savings deposit exceed the expected rate of inflation in that country. The logic is that the savers would only be willing to save money if their savings grow at a faster rate than the prices of the products that they may buy in the future. The nominal interest rate that is offered on savings deposits represents the return to local savers, and therefore that rate should exceed the expected inflation rate in order to attract savings. This implies that the real (inflation- adjusted) interest rate should be positive:
Real interest rate¼ðNominal interest rateExpected inflation rateÞ> 0
By rearranging terms, the nominal interest rate can be derived as follows:
Nominal interest rate¼Real interest rateþExpected inflation rate
If the real interest rate required by savers was, say, 2 percent, and if savers expected inflation to be 1 percent, then financial institutions would need to offer a nominal inter- est rate of 3 percent to entice potential savers to invest in deposits:
Nominal interest rate¼Real interest rate þ Expected inflation rate
¼2%þ1%
¼3%
Assuming the real interest rate is constant over time, then any change in expected inflation over time would lead to a change in the nominal interest rate that financial institutions would have to offer on savings deposits to attract savers. For example, if expected inflation changed from 1 percent to 3 percent, financial institutions would have to offer a nominal interest rate of:
266 Part 2:Exchange Rate Behavior
Nominal interest rate¼Real interest rate þ Expected inflation rate
¼2%þ3%
¼5%
We cannot directly observe the expected inflation rate that a country’s citizens antici- pate, because that would require obtaining the opinions of all the citizens. However, we can rearrange the terms above to derive a country’s expected inflation rate:
Expected inflation rate¼Nominal interest rateReal interest rate
Thus the differential in expected inflation between countries A and B is:
Expected inflation differential¼EðINFAÞEðINFBÞ
¼ðiARealAÞðiBRealBÞ
Assuming that the real rate of interest required is the same for savers in all countries, RealA¼RealB, the expected inflation differential can be reduced to:
Expected inflation differential¼iAiB
This formula is very powerful because it suggests that if the real interest rate required by savers is similar across countries, then the difference between expected inflation rates of two countries can be derived simply from the difference between their respective nominal interest rates.
EXAMPLE Assume that the real rate of interest is 2 percent in both Canada and the United States, and assume that the nominal one-year interest rate is 13 percent in Canada versus 8 percent in the United States. Accord- ing to the Fisher effect, the expected one-year inflation rate in Canada is 13%2%¼11%; for the United States, it is 8%2%¼6%. Therefore, the difference in expected inflation over the next year between the two countries is 11%6%¼5%, which is equal to the difference in their nominal one- year interest rates (13%8%¼5%).l
8-2b Estimating the Expected Exchange Rate Movement
Once the expected inflation rates of two countries have been derived from the nominal interest rates (based on the Fisher effect) as just described, the PPP theory can be applied to estimate how the expected inflation rate differential will affect exchange rates.
EXAMPLE Recall from the preceding example that Canada has an expected inflation rate of 11 percent over the next year versus 6 percent in the United States. Because the expected inflation is 5 percent higher in Canada, PPP suggests that the Canadian dollar should depreciate against the U. dollar by about 5 percent over the next year. If the Canadian dollar depreciates by 5 percent over the next year, U. savers who attempted to benefit from the higher Canadian interest rate would receive 5 percent less when convert- ing Canadian dollars back to U. dollars than what they originally paid to obtain Canadian dollars. This would offset the 5 percent interest rate advantage that they received from investing in Canadian savings deposits instead of U. savings deposits. Thus their expected return from the Canadian deposits would be 8 percent, similar to the return that they could earn from a one-year savings deposit in the United States. Consequently, U. savers would not benefit from investing in Canadian savings deposits
8-2c Implications of the International Fisher Effect
If the IFE holds, countries with high interest rates should exhibit high expected inflation (as explained by the Fisher effect), so that the currencies of these countries with relatively
Chapter 8:Relationships among Inflation, Interest Rates, and Exchange Rates 267
Implications if the Offsetting Effect Is Not Perfect The exchange rate will
not always respond to the difference in country inflation rates exactly as suggested by the IFE in every period. Thus the exchange rate’s movement might not fully offset the inter- est rate advantage in some periods, allowing investors based in countries with low inter- est rates to benefit from investing in the high-interest-rate country. In other periods, the exchange rate movement might more than offset the interest rate advantage, thereby causing investors based in low-interest-rate countries to be worse off from investing in the high-interest-rate country. But the IFE theory would suggest that over several peri- ods, the exchange rate effect should fully offset the interest rate advantage on average. Thus savers based in low-interest-rate countries will not earn higher returns on average from periodically investing in high-interest-rate countries than what they can earn domestically. Exhibit 8 summarizes how the IFE theory applies to the three examples described above. Notice that the interest rate differential (second column) is equal to the expected inflation rate differential (third column) between two countries, which is equal to the degree by which the currency in the relatively high interest rate country should depreci- ate (fourth column). That is, a relatively high interest rate reflects a relatively high expected inflation rate, which should cause depreciation of the currency in the high- interest-rate country. This exhibit illustrates how, according to the IFE, the exchange rate movement (fourth column) is expected to offset the interest rate advantage (second
Exhibit 8 Summary of Application of the International Fisher Effect to Three Different Investment Scenarios
INITIAL INFORMATION ASSUMED IN THE EXAMPLES
COUNTRY
PREVAILING NOMINAL ONE-YEAR INTEREST RATE
REAL INTEREST RATE REQUIRED BY SAVERS Canada 13% 2% United States 8% 2% Japan 5% 2% APPLICATION OF THE INTERNATIONAL FISHER EFFECT (IFE)
SCENARIO
NOMINAL INTEREST RATE DIFFERENTIAL OF FOREIGN SAVINGS DEPOSIT VERSUS HOME DEPOSIT
EXPECTED INFLA- TION DIFFERENTIAL BETWEEN FOREIGN COUNTRY AND HOME COUNTRY (BASED ON FISHER EFFECT)
EXPECTED EXCHANGE RATE MOVEMENT DERIVED FROM APPLYING PPP TO EXPECTED INFLATION DIFFERENTIAL
EXPECTED RETURN ON FOREIGN SAVINGS DEPOSIT
RETURN TO SAVER WHO IN- VESTS IN HOME SAVINGS DEPOSIT U. investor invests in Canadian bank deposit
13%8%¼5% 11%6%¼5% 5% 13%5%¼8% 8%
Japanese investor invests in U. savings deposit
8%5%¼3% 6%3%¼3% 3% 8%3%¼5% 5%
Japanese investor invests in Canadian savings deposit
13%5%¼8% 11%3%¼8% 8% 13%8%¼5% 5%
Chapter 8:Relationships among Inflation, Interest Rates, and Exchange Rates 269
column), such that the expected return to investors from investing in the foreign savings deposit (fifth column) is no better than the return they could have earned domestically (sixth column).
8-2d Derivation of the International Fisher Effect
According to the IFE, the precise relationship between the nominal interest rate differen- tial of two countries and the expected exchange rate change can be derived as follows. Note that the actual return to investors who invest in money market securities (such as short-term bank deposits) in their home country is simply the nominal interest rate offered on those securities. However, the actual return to investors who invest in a for- eign money market security depends not only on the foreign interest rate (if) but also the percentage change in the value of the foreign currency (ef) denominating that security. The formula for the actual or“effective”(exchange rate–adjusted) return on a foreign bank deposit, or any other money market security, is
r¼ 1 ð 1 þifÞð 1 þefÞ 1
The IFE theory states that the effective return on a foreign investment should, on average, be equal to the interest rate on a local money market investment:
EðrÞ¼ih
whereris the effective return on the foreign deposit andihis the interest rate on the home deposit. Hence we can determine the degree by which the foreign currency must change in order to make investments in both countries generate similar returns. Take the previous formula definingrand set it equal toihas follows:
r ¼ih
ð 1 þifÞð 1 þefÞ 1 ¼ih
Now solve foref
ð 1 þifÞð 1 þefÞ¼ 1 þih
1 þef¼
1 þih
1 þif
ef¼
1 þih
1 þif
1
As verified here, the IFE theory contends that ifih>if, thenefwill be positive because the relatively low foreign interest rate reflects relatively low inflationary expectations in the foreign country. That is, the foreign currency will appreciate when the foreign inter- est rate is lower than the home interest rate. This appreciation will improve the foreign return to investors from the home country, making returns on foreign securities similar to returns on home securities. Conversely, ifif>ih, thenefwill be negative. That is, the foreign currency will depreciate when the foreign interest rate exceeds the home interest rate. This depreciation will reduce the return on foreign securities from the perspective of investors in the home country, making returns on foreign securities no higher than returns on home securities.
Numerical Example Based on Derivation of the IFE Given two interest
rates, the value ofefcan be determined from the formula just derived and then used to forecast the exchange rate.
####### WEB
newyorkfed Exchange rate and interest rate data for various countries.
270 Part 2:Exchange Rate Behavior
exchange rate (according to IFE theory). This means that the IFE is more applicable when the two countries of concern engage in considerable international trade with each other. If there is not much trade between the two countries, their inflation differential should not have a major impact on that trade, and there is no reason for expecting that the exchange rate will change in response to the interest rate differential. So in this case, even a large interest rate differential (which signals a large differential in expected infla- tion) would have a negligible effect on trade between the countries. Investors might then be more willing to invest in a foreign country with a high interest rate, although the cur- rency of that country could still weaken for other reasons.
Simplified Relationship A simplified (but less precise) relationship specified by
the IFE is
efihif
That is, the percentage change in the exchange rate over the investment horizon will equal the interest rate differential between two countries. This approximation provides reasonable estimates only when the interest rate differential is small.
8-2e Graphic Analysis of the International Fisher Effect
Exhibit 8 displays the set of points that conform to the argument behind IFE theory. For example, point E reflects a case where the foreign interest rate exceeds the home interest rate by 3 percentage points; observe that the foreign currency has depreciated
Exhibit 8 Illustration of IFE Line (When Exchange Rate Changes Perfectly Offset Interest Rate Differentials)
% in the Foreign Currency’s Spot Rate
IFE Line
ih – if (%)
–3 – -
1 3
1
3
E –
J
55–
5
F
H G
272 Part 2:Exchange Rate Behavior
by 3 percent to offset its interest rate advantage. Thus an investor setting up a deposit in the foreign country achieves a return similar to what is possible domestically. Point F represents a home interest rate that is 2 percent above the foreign interest rate. In this case, investors from the home country who establish a foreign deposit must accept a lower interest rate; however, IFE theory suggests that the currency should appreciate by 2 percent to offset that interest rate disadvantage. Point F in Exhibit 8 also illustrates the IFE from a foreign investor’s perspective, for whom the home interest rate will appear attractive. However, IFE theory suggests that the foreign currency will appreciate by 2 percent; from the foreign investor’s perspective, this implies that the home country’s currency denominating the investment instruments will depreciate to offset the interest rate advantage.
Points on the IFE Line All the points along theinternational Fisher effect (IFE)
linein Exhibit 8 reflect exchange rate adjustments to offset the differential in interest rates. This means that when accounting for the exchange rate movements, investors will end up achieving the same return (yield) whether they invest at home or in a foreign country.
Points below the IFE Line Points below the IFE line generally reflect the higher
returns from investing in foreign deposits. For example, point G in Exhibit 8 indicates that the foreign interest rate exceeds the home interest rate by 3 percent. In addition, the foreign currency has appreciated by 2 percent. The combination of the higher foreign interest rate plus the appreciation of the foreign currency will cause the foreign return to be higher than what is possible domestically. If actual data were compiled and plotted and if the vast majority of points were below the IFE line, this would suggest that home country investors could consistently increase their investment returns by establishing for- eign bank deposits. Such results would refute the IFE theory.
Points above the IFE Line Points above the IFE line generally reflect returns
from foreign deposits that are lower than the returns that are possible domestically. For example, point H reflects a foreign interest rate that is 3 percent above the home interest rate. Yet point H also indicates that the exchange rate of the foreign currency has depre- ciated by 5 percent, more than offsetting its interest rate advantage. As another example, point J represents the case where a home country investor is dis- couraged from investing in a foreign deposit for two reasons. First, the foreign interest rate is lower than the home interest rate. Second, the foreign currency depreciates during the time the foreign deposit is held. If actual data were compiled and plotted and if the vast majority of points were above the IFE line, this would suggest that home country investors would consistently receive lower returns from foreign than from home country investments. Such results would also refute the IFE theory.
8-2f Testing the International Fisher Effect
If the actual points (one for each period) of interest rates and exchange rate changes were plotted over time on a graph such as Exhibit 8, we could determine whether the points are systematically below the IFE line (suggesting higher returns from foreign investing than domestic investing), above the line (suggesting lower returns from foreign investing than domestic investing), or evenly scattered on both sides (suggesting a bal- ance of higher returns from foreign investing than domestic investing in some periods and lower foreign returns than domestic investing in other periods). If foreign money market securities (such as bank deposits) are expected to provide about the same yield as domestic money market securities on average, then a U. firm would
####### WEB
economagic U. inflation and exchange rate data.
Chapter 8:Relationships among Inflation, Interest Rates, and Exchange Rates 273
8-2h IFE Theory versus Reality
The IFE theory contradicts the arguments in Chapter 4 about how a country with a high interest rate can attract more capital flows and therefore cause the local currency’s value to strengthen. The IFE theory also contradicts the arguments in Chapter 6 about how a central bank may purposely try to raise interest rates in order to attract funds and strengthen the value of its local currency. In reality, a currency with a high interest rate strengthens in some situations, which is consistent with the points made in Chapters 4 and 6 but contrary to the IFE. Many MNCs frequently invest in money market securities in developed foreign countries where they can earn a slightly higher interest rate. They may believe that the higher interest rate advantage of the foreign money market securi- ties is due to factors other than higher expected inflation or that any impact of inflation will not offset the interest rate advantage over the investment horizon. Whether the IFE actually holds depends on the countries involved and also on the periods that are assessed. The IFE theory may be especially meaningful in cases when MNCs and large investors consider investing in countries where prevailing interest rates are extremely high. These countries tend to be less developed and to have higher infla- tion, and their currencies tend to weaken substantially over time. The depreciation in the currencies of these countries could more than offset the interest rate advantage and might even cause U. investors to experience a loss on their money market investments. Investors could also experience a loss on money market investments in developed coun- tries, but the likelihood of inflation causing a substantial depreciation of their currencies is much lower.
8-2i Comparison of IRP, PPP, and IFE Theories
At this point, it may be helpful to compare three related theories of international finance: interest rate parity (IRP), discussed in Chapter 7; purchasing power parity (PPP); and the international Fisher effect (IFE). Exhibit 8 summarizes the main themes of each theory. Even though all three of these theories relate to the determina- tion of exchange rates, they have different implications. The IRP theory focuses on why the forward rate differs from the spot rate and on how much the difference should be at a specific point in time. In contrast, the PPP theory and IFE theory both focus on how a currency’s spot rate will change over time. Whereas PPP theory suggests that the spot rate will change in accordance with the inflation differential between two countries, IFE theory suggests that it will change in accordance with the nominal interest rate dif- ferential (and therefore in accordance with the expected inflation rate differential) between two countries. The IFE relies on the Fisher effect to determine how the differ- ential in expected inflation rates between two countries can be measured based on the prevailing nominal interest rate differential, and then it applies PPP theory to predict how the exchange rate between the two countries will change based on the differential in expected inflation rates. Some generalizations about countries can be made by applying these theories. High- inflation countries tend to have high nominal interest rates (due to the Fisher effect). Their currencies tend to weaken over time (because of the PPP and IFE), and the for- ward rates of their currencies normally have large discounts (due to IRP). Financial managers who believe in PPP recognize that the exchange rate movement in any particular period will not always move according to the inflation differential between the two countries of concern. Even so, these managers may still rely on the inflation dif- ferential in order to derive their best guess of the expected exchange rate movement. Financial managers who believe in the IFE recognize that the exchange rate in any
Chapter 8:Relationships among Inflation, Interest Rates, and Exchange Rates 275
particular period will not always move according to the nominal interest rate differential between the two countries of concern; yet they may still rely on the nominal interest rate differential in order to derive their best guess of the expected exchange rate movement.
Exhibit 8 Comparison of the IRP, PPP, and IFE Theories
Interest Rate Differential
Forward Rate Discount or Premium
Innation Rate Differential
Exchange Rate Expectations
Interest Rate Parity (IRP)
International Fisher Effect (IFE)
Fisher Effect
PPP
THEORY KEY VARIABLES OF THEORY SUMMARY OF THEORY Interest rate parity (IRP)
Forward rate premium (or discount)
Nominal interest rate differential
The forward rate of one currency with respect to another will contain a premium (or discount) that is determined by the differential in interest rates between the two countries. As a result, covered interest arbitrage will provide a return that is no higher than a domestic return. Purchasing power parity (PPP)
Percentage change in spot exchange rate
Inflation rate differential
The spot rate of one currency with respect to another will change in reaction to the differential in inflation rates between the two countries. Consequently, the purchasing power for consumers when purchasing products in their own country will be similar to their purchasing power when importing products from the foreign country. International Fisher effect (IFE)
Percentage change in spot exchange rate
Nominal interest rate differential
The spot rate of one currency with respect to another will change in accordance with the differential in nominal interest rates between the two countries (and thus with the expected inflation rate differential). Consequently, the return to investors from investing in foreign money market securities will, on average, be no higher than the return on domestic money market securities.
SUMMARY
■ Purchasing power parity (PPP) theory specifies a precise relationship between the relative inflation rates of two countries and their exchange rate. PPP theory suggests that the equilibrium exchange rate
will adjust by about the same magnitude as the difference between the two countries’ inflation rates. While there is evidence of significant real- world deviations from the theory, PPP offers a
276 Part 2:Exchange Rate Behavior
Chapter 8 Inflation, interest rate and exchange rate PPP, Fisher
Course: Finance (FIN300)
University: Đại học Kinh tế Quốc dân
