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Relationship CHAPTER among Inflation,
Interest Rates, and Exchange Rates
Interest Rate Parity (IRP)
Purchasing Power Parity (PPP)
International Fisher Effect (IFE)
Dr. C. Singh
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IRP
Theory specifying the relationship between the FC
forward premium (or discount) and relative interest
rates (the HC-FC-interest-rate differential).
Suggests that the FC forward premium (or discount)
will adjust to offset the interest-rate differential
between two currencies.
The presence of IRP implies that (F-S)/S = (ihc- ifc)/(1+ifc)
Chapter 8: Relationship among Inflation, Interest Rates, and ERs
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PPP
Theory specifying the relationship between relative
inflation rates and the corresponding ER between two
currencies.
Suggests that the equilibrium ER will adjust to offset
the inflation-rate differential between two currencies.
Example: The inflation rates in US and UK are initially zero. If the US, now,
experiences an inflation rate of 5%, and the UK an inflation rate of 3%, the
ER of GBP in USD must appreciate by about 2% (inflation-rate differential)
according to the PPP theory.
The presence of PPP implies that % in the [FC] ER
(hc- fc)/(1+fc), where, hc is the HC inflation rate,
and fc is the FC inflation rate.
Chapter 8: Relationship among Inflation, Interest Rates, and ERs
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IFE
Theory specifying relationship the between relative
interest rates and the corresponding ER between two
currencies.
Suggests that the equilibrium ER will adjust to offset
the interest-rate differential between two currencies.
Example: If the one-year US nominal interest rate is 3% higher than the
Japanese nominal interest rate, the IFE (based on PPP theory) suggests
that the yen would appreciate by about 3% over one year so that the
effective return on one-year investments in both countries is about the
same.
The IFE implies that % in the [FC] ER = (ihc- ifc)/(1+ifc)
where, ihc is the HC nominal interest rate, and ifc is
the FC nominal interest rate.
Chapter 8: Relationship among Inflation, Interest Rates, and ERs
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IRP and IFE
If both IFE and IRP hold, % in the [FC] ER (F-S)/S
Suggests that the equilibrium ER will adjust to offset
the FC forward premium (or discount).
Chapter 8: Relationship among Inflation, Interest Rates, and ERs
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Exchange Rates Over Time
To forecast exchange-rate fluctuations between two
currencies in the long run, economists use (among
other factors):
Inflation-rate differentials
Interest-rate differentials
Chapter 8: Relationship among Inflation, Interest Rates, and ERs
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CHAPTER 8
Relationship among Inflation,
Interest Rates, and Exchange Rates
Dr. C. Singh
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