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 105
106 International Financial Management 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 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. 4. Provide a simple explanation of the difference between interest rate parity (from the previous chapter), PPP (from this chapter), and IFE (from this chapter). POINT/COUNTER-POINT: Does PPP Eliminate Concerns about Long-Term Exchange Rate Risk? POINT : 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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