Relationships among inflation and exchange rate

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Relationships among inflation and exchange rate

  1. 1. ◦ Direct quote ◦ Price of the foreign currency in terms of home currency ◦ Indirect quote ◦ Price of the home country in terms of the foreign currency
  2. 2. Foreign Exchange rate  P.p.p  Deviation of P.P.P  I.F.E  Derivation of I.F.E  Compression of I.R.P,  p.p.p, I.F.E 
  3. 3.  theory attempts to quantify this inflation – exchange rate relationship.  When a country’s inflation rate increase relative to another country, decreased exports and increased imports depress the high-inflation country’s currency.
  4. 4. Assume that PPP holds. Over time, inflation occurs and the exchange rate adjusts to maintain PPP: Ph = home country’s price index Ih = home country’s inflation rate Pf  Pf (1 + If ) (1 + ef ) where Pf = foreign country’s price index If = foreign country’s inflation rate ef = foreign currency’s % D in value where
  5. 5. PPP holds Ph = Pf and Ph (1 + Ih ) = Pf (1 + If ) (1 + ef ) Solving for ef : ef = (1 + Ih ) – 1 (1 + If )
  6. 6. PPP does not occur consistently due to:  Exchange rates are also affected by differences in inflation, interest rates, income levels, government controls and expectations of future rates.  for some traded goods
  7. 7.  Absolute form of PPP: “ ”: price of similar products to two countries should be equal when measured in a common currency.
  8. 8.  Acknowledges market imperfections such as:  Rate of change in the prices of products should be similar when measured in a common currency.
  9. 9.  I.F.E describe that inflation and both real and nominal interest rate. The fisher effect state that the real interest rate equal the nominal interest rate minus expected inflation. therefore real interest rate fall as inflation increase unless nominal interest rate increase at the same rate
  10. 10.  Setting rf = rh : (1 + if )(1 + ef ) – 1 = ih  When the interest rate differential is small, the IFE relationship can be simplified as ef ih _ if
  11. 11. (PPP)
  12. 12. Forward rate premium Interest rate differential p ih – if p % in spot exchange rate ef Inflation rate differential Ih – If % in spot exchange rate ef Interest rate differential ih – if ef ef 1 ih 1 if 1 Ih 1 If 1 ih 1 if 1 ih i f 1 Ih If 1 ih if

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