Fin 370 -notes # 3

Fin 370 -notes # 3 - Chapter Objectives To explain the...

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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 To compare the PPP, IFE, and interest rate parity (IRP) theories. 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 . The relative form of PPP accounts for market imperfections like transportation costs, tariffs, and quotas . It states that the rate of price changes should be similar. Rationale behind PPP theory Suppose U.S. inflation > U.K. inflation increase U.S. imports from U.K. and decrease U.S. exports to U.K. Upward pressure in placed on the pound. This shift in the consumption and the pound’s appreciation will continue until: 1. in the U.S.: price of U.K. goods is greater than or equal to price of U.S. goods 2. in the U.K.: price of U.S. goods is less than or equal to price of U.K. goods Derivation of PPP Assume that PPP holds. Over time, inflation occurs and the exchange rate adjusts to maintain PPP. 1. Ph -> Ph(1+Ih), where Ph = home country’s price index and Ih is home country’s inflation rate. 2. Pi -> Pf(1+If)(1+ef), where Pf = foreign country’s price index, If = foreign country’s inflation rate, and ef = PPP holds => Ph = Pf , and Ph (1+Ih) = Pf(1+If)(1+ef) Solving for ef: ef= (1+Ih)-1/(1+If) Ih > If => ef > 0 , foreign currency appreciates Ih < If => ef > 0 , foreign currency depreciates Simplified PPP relationship When inflation differential is small, the PPP relationship can be simplified as: Ef = Ih - If Testing the PPP Theory: statistical test Apply regression analysis to historical exchange rates and inflation differentials: Then apply t-tests to the regression coefficients. If any coefficient differs significantly from what was expected, PPP does not hold. Why PPP does not occur: PPP does not occur consistently due to: Confounding effects - Exchange rate are also affect by differences in inflation, interest rates, income levels, government controls and expectations of future rates A lack of substitutes for some traded goods International Fisher Effect (IFE) According to the Fisher effect, nominal risk-free interest rates contain a real rate of return and anticipated inflation. 1
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If all investors require the same real return, differentials in interest rates may be due to differentials in expected inflation. Recall that PPP theory suggest that exchange rate movements are caused by inflation rate differentials. The international Fisher effect (IFE) theory suggests that currencies with higher interest rates will depreciate because the higher nominal rates reflect higher expected inflation .
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Fin 370 -notes # 3 - Chapter Objectives To explain the...

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