Académique Documents
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Chapter Objectives
To explain the purchasing power parity
(PPP) and international Fisher effect (IFE)
theories, and their implications for
exchange rate changes; and
8-2
8-3
Interpretations of PPP
The absolute form of PPP is an extension
of the law of one price. It suggests that the
prices of the same products in different
countries should be equal when measured
in a common currency.
Derivation of PPP
Assume that PPP holds.
Over time, inflation occurs and the exchange
rate adjusts to maintain PPP:
Ph Ph (1 + Ih )
where Ph = home countrys price index
Ih
= home countrys inflation rate
Pf Pf (1 + If ) (1 + ef )
where Pf = foreign countrys price index
If
= foreign countrys inflation rate
ef
= foreign currencys % in value
8-6
Derivation of PPP
PPP holds Ph = Pf and
Ph (1 + Ih ) = Pf (1 + If ) (1 + ef )
Solving for ef :
(1 + If )
ef = (1 + Ih ) 1
PPP line
-1
1
-2
D
-4
Decreased
purchasing
power of
foreign
goods
% in the
foreign
currencys
spot rate
8-9
8 - 10
ef = a0 + a1 [ (1+Ih)/(1+If) 1 ] +
8 - 13
confounding effects
Ih If
ef
if
Return in
Home
Currency
Ih
Real
Return
Earned
Japan
Japan
U.S.
Canada
3% 3%
3 6
3 11
0 % 5%
3
8
8
13
5%
5
5
3%
3
3
2%
2
2
U.S.
Japan
U.S.
Canada
6 3
6 6
6 11
3
0
5
5
8
13
8
8
8
6
6
6
2
2
2
Canada Japan
U.S.
Canada
11 3
11 6
11 11
8
5
0
5
8
13
13
13
13
11
11
11
2
2
2
8 - 18
rf = (1 + if ) (1 + ef ) 1
if = interest rate in the foreign country
ef= % change in the foreign currencys
value
ef ih
if
IFE line
-1
-2
B
D
-4
% in the
foreign
Higher
returns from currencys
investing in spot rate
foreign
deposits
8 - 22
8 - 24
IFE line
-3
-1
1
-2
-4
% in the
foreign
currencys
spot rate
8 - 25
ef = a0 + a1 [ (1+ih)/(1+if) 1 ] +
8 - 26
8 - 27
Interest Rate
Differential
Fisher
Effect
Forward Rate
Discount or Premium
Inflation Rate
Differential
Purchasing (PPP)
Power Parity
International
Fisher Effect (IFE)
Exchange Rate
Expectations
8 - 28
1 ih
p
1 i
1 i
if
1 Ih
% in spot exchange rate ef
ef
1 Ih I f
1 I f
Inflation rate differential Ih If
ef
1 ih
1 i
1 i
if
8 - 29