Chap 8

Chapter 8

Relationships Among Inflation,

Interest Rates, and Exchange Rates

Lecture Outline

Purchasing Power Parity (PPP)

Interpretations of PPP

Rationale Behind PPP Theory

Derivation of PPP

Using PPP to Estimate Exchange Rate Effects

Graphic Analysis of PPP

Testing the PPP Theory

Why PPP Does Not Occur

PPP in the Long Run

International Fisher Effect (IFE)

Implications of the IFE for Foreign Investors

Derivation of the IFE

Graphic Analysis of the IFE

Tests of the IFE

Why the IFE Does Not Occur

Comparison of IRP, PPP, and IFE Theories

Chapter Theme

This chapter discusses the relationship between inflation and exchange rates according to the purchasing power parity (PPP) theory.  Since this is one of the most popular subjects in international finance, it is covered thoroughly.  While PPP is a relevant theory, it should be emphasized that PPP will not always hold in reality.  It does however, provide a foundation in understanding how inflation can affect exchange rates.  The international Fisher effect (IFE) is also discussed in this chapter.  This theory is also very important.  Yet, it should again be emphasized that this theory does not always hold.  If the PPP and IFE theories held consistently, decision making by MNCs would be much easier.  Because these theories do not hold consistently, an MNC’s decision making is very challenging.

Topics to Stimulate Class Discussion

1. Provide reasoning for why highly inflated countries such as Brazil tend to have weak home currencies.

2. Identify the inflation rate of your home country and some well-known foreign country.  Then identify the percentage change of your home currency with respect to that foreign country.  Did the currency change in the direction and by the magnitude that you would have expected according to PPP?  If not, offer possible reasons for this discrepancy.

3. Identify the quoted one-year interest rates in your home country and in a...