Ch. 8 Inlation, Intrst Rats & FX Rats Topics Purchasing Powr Parity Intrnational Fishr Ect Purchasing Powr Parity Purchasing Powr Parity (PPP: Th purchasing powr o a consumr will b similar whn purchasing goods in a orign country or in th hom country. I inlation in a orign country dirs rom inlation in th hom country, th xchang rat will adjust to maintain qual purchasing powr. Currncis in countris with high inlation will b wak according to PPP. Purchasing Powr Parity ( I h = ( I whr, = % chang in th valu o th orign currncy I h = inlation rat in th hom country I = inlation rat in th orign country
Purchasing Powr Parity Th absolut orm o PPP, or th law o on pric, suggsts that similar products in dirnt countris should b qually pricd whn masurd in th sam currncy. Th rlativ orm o PPP accounts or markt imprctions lik transportation costs, taris, and quotas. It stats that th rat o pric changs should b similar. Rational Bhind PPP Thory Suppos inlation is high in a particular country. Forign dmand or goods in that country will dcras. In addition, that country s dmand or orign goods should incras. Thus, th hom currncy o that country will wakn. This tndncy should continu until th currncy has waknd to th xtnt that a orign country s goods ar no mor attractiv than th hom country s goods. Inlation dirntials ar ost by xchang rat changs. Idntiying Disparity in Purchasing Powr 2
Tsting th PPP ( I US = a 0 a ε ( I Statistical Tst Apply rgrssion analysis to th historical xchang rats and inlation dirntials. Th appropriat t-tsts ar thn applid to a 0 and a, whos hypothsizd valus ar 0 and rspctivly. Tsting th PPP Tsting th PPP Empirical studis indicat that th rlationship btwn inlation dirntials and xchang rats is not prct vn in th long run. PPP dos not consistntly hold bcaus thr ar othr actors bsids inlation that inluncs xchang rats. Intrst rats Incom lvls Risk Govrnmnt controls In addition, thr may not b substituts or tradd goods. I substituts ar not availabl, th orign dmand or its products will not ncssarily dcras vn whn a country s inlation incrass (in th mannr suggstd by PPP. Howvr, th us o inlation dirntials to orcast long-run movmnts in xchang rats is supportd. 3
Intrnational Fishr Ect Fishr ct: Nominal risk-r intrst rats contain a ral rat o rturn and an anticipatd inlation. I th sam ral rturn is rquird, dirntials in intrst rats may b du to dirntials in xpctd inlation. According to PPP, xchang rat movmnts ar causd by inlation rat dirntials. Intrnational Fishr Ect Intrnational Fishr Ect (IFE: A currncy s valu will adjust in accordanc with th dirntial in intrst rats btwn two countris. According to th IFE, E(r, th xpctd ctiv rturn on a orign mony markt invstmnt, should qual r h, th ctiv rturn on a domstic invstmnt. Consquntly, a irm that consistntly purchass orign Trasury bills will on avrag arn a similar rturn as domstic Trasury bills. I a particular currncy xhibits a high nominal intrst rat, this may rlct a high anticipatd inlation. Thus, th inlation will plac downward prssur on th currncy s valu i it occurs. Intrnational Fishr Ect ( i h = ( i whr, = % chang in th valu o th orign currncy i h = intrst rat in th hom country i = intrst rat in th orign country 4
Tsting th IFE ( i US = a 0 a ε ( i Statistical Tst Apply rgrssion analysis to th historical xchang rats and inlation dirntials Th appropriat t-tsts ar thn applid to a 0 and a, whos hypothsizd valus ar 0 and rspctivly. Tsting th IFE Sinc th IFE is basd on PPP, it will not hold whn PPP dos not hold. For instanc, i thr ar actors othr than inlation that act xchang rats, th rats will not adjust in accordanc with th inlation dirntial. Comparison o th IRP, PPP, and IFE Although all thr thoris rlat to th dtrmination o xchang rats, thy hav dirnt implications. IRP ocuss on why th orward rat dirs rom th spot rat and on th dgr o dirnc that should xist. It rlats to a spciic point in tim. PPP and IFE ocus on how a currncy s spot rat will chang ovr tim. Whras PPP suggsts that th spot rat will chang in accordanc with inlation dirntials, IFE suggsts that it will chang in accordanc with intrst rat dirntials. PPP is rlatd to IFE bcaus xpctd inlation dirntials inlunc th nominal intrst rat dirntials btwn two countris. 5
Comparison o IRP, PPP, and IFE Intrst Rat Parity (IRP Forward Rat Discount or Prmium Intrst Rat Dirntial Intrnational Fishr Ect Fishr Ect (IFE Purchasing Powr Parity Inlation Rat Dirntial (PPP Exchang Rat Expctations 6