Module : 1

Session 4:

International Parity Relationships among Inflation, Interest Rates and Exchange

Rates

Session Overview

A. Purchasing Power Parity (PPP)

B. International Fisher Effect (IFE)

C. Interest Rate Parity (IRP)

D. Comparison of the IRP, PPP, and IFE Theories

Session Objectives

A. Explain the purchasing power parity (PPP) theory and its implications for exchange rate changes

B. Explain the International Fisher effect (IFE) theory and its implications for exchange rate changes

C. Compare the PPP theory, the IFE theory, and the theory of interest rate parity (IRP)

A. Purchasing Power Parity (PPP)

1. Interpretations of Purchasing Power Parity

a. Absolute Form of PPP

b. Relative Form of PPP

2. Rationale behind Purchasing Power Parity Theory

3. Derivation of Purchasing Power Parity

A. Purchasing Power Parity (PPP)

4. Using PPP to Estimate Exchange Rate Effects

a. Using a Simplified PPP Relationship

5. Graphic Analysis of Purchasing Power Parity

a. PPP Line

b. Purchasing Power Disparity

8.1

Illustration of Purchasing Power Parity

A. Purchasing Power Parity (PPP)

6. Testing the Purchasing Power Parity Theory

a. Conceptual Tests of PPP1.) choose two countries (say, the United States and a foreign country)

2.) compare the differential in their inflation rates to the percentage change in the foreign currency’s

value during several time periods.

8.2

Identifying Disparity in Purchasing Power

A. Purchasing Power Parity (PPP)

b. Statistical Test of PPP

c. Results of Tests of PPP

d. Tests of PPP for Each Currency

e. Limitations of PPP Tests

8.3

Comparison of Annual Inflation Differentials and Exchange Rate MovementsFor Four Major Currencies

A. Purchasing Power Parity (PPP)

7. Why Purchasing Power Parity Does Not Occur

a. Confounding Effects

b. No Substitutes for Traded Goods

B. International Fisher Effect (IFE)

1. Relationship with Purchasing Power Parity

2. Implications of the IFE for Foreign Investors

B. International Fisher Effect (IFE)

3. Derivation of the International Fisher Effect

a. Numerical Example based on the Derivation of IFE

b. Simplified Relationship

B. International Fisher Effect (IFE)

4. Graphic Analysis of the International Fisher Effect

a. Points on the IFE Line

b. Points below the IFE Line

c. Points above the IFE Line

8.5

Illustration of IFE Line (When Exchange Rate Changes Perfectly Offset InterestRates Differentials)

B. International Fisher Effect (IFE)

5. Test of the International Fisher Effect

a. Results from testing the IFE

b. Statistical Test of the IFE

B. International Fisher Effect (IFE)

6. Why the international Fisher Effect Does Not Occur

a. PPP does not hold in certain times

b. Since IFE based on PPP, it does

not hold consistently either

C. Interest Rate Parity (IRP)

1. Concept of Interest Rate Parity

2. Determining the Forward Premium

a. Relationship between Forward Premium and Interest Rate Differential

b. Implications

C. Interest Rate Parity (IRP)

3. Graphic Analysis of Interest Rate Parity

a. Points Representing a Discount

b. Points Representing a Premium

c. Points representing IRP

7.9

Illustration of Interest Rate Parity

C. Interest Rate Parity (IRP)

4. How to Test Whether Interest Rate Parity Exists

5. Interpretation of Interest Rate Parity

6. Does Interest Rate Parity Hold?

C. Interest Rate Parity (IRP)

7. Consideration When Assessing Interest Rate Parity

a. Transaction Costs

b. Political Risk

c. Differential Tax Laws

8. Forward Premiums across Maturity Markets

9. Changes in Forward Premiums

D. Comparison of the IRP, PPP, and IFE Theories

8.7