Relationships among Inflation,
Interest Rates, and Exchange Rates
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
International Financial Management
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. However, it provides 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
Provide reasoning for why highly inflated countries tend to have weak home currencies.
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.
Identify the quoted one-year interest rates in your home country and in a well-known foreign
country as of one year ago. Also determine how your home currency changed relative to this
foreign currency over the last year. Did the currency change according to the IFE theory? If not,
does this information disprove IFE? Elaborate.
Provide a simple explanation of the difference between interest rate parity (from the previous
chapter), PPP (from this chapter), and IFE (from this chapter).
Does PPP Eliminate Concerns about Long-Term Exchange Rate Risk?
Yes. Studies have shown that exchange rate movements are related to inflation differentials
in the long run. Based on PPP, the currency of a high-inflation country will depreciate against the
dollar. A subsidiary in that country should generate inflated revenue from the inflation, which will
help offset the adverse exchange effects when its earnings are remitted to the parent. If a firm is
focused on long-term performance, the deviations from PPP will offset over time. In some years, the
exchange rate effects may exceed the inflation effects, and in other years the inflation effects will
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