Chapter 8 slides , Jeff medura's book

3. Interpretations of Purchasing Power Parity:
Interpretations of Purchasing Power Parity (PPP) refer to
different perspectives on the concept's implications for
exchange rates. There are two main interpretations:
absolute PPP and relative PPP. Absolute PPP suggests
that the exchange rate should equalize the prices of
identical goods in different countries, implying a direct
relationship between inflation differentials and exchange
rate movements. Relative PPP, on the other hand,
considers the changes in relative prices over time and
focuses on inflation differentials as predictors of future
exchange rate movements. The interpretations of PPP
provide insights into the relationship between inflation,
exchange rates, and purchasing power, and they guide
the analysis of exchange rate effects and forecasting.

4. Rationale behind Relative PPP Theory: The rationale
behind Relative Purchasing Power Parity (PPP) theory
stems from the idea that exchange rates should adjust to
reflect differences in inflation rates between countries.
According to this theory, if one country has a higher
inflation rate than another, its currency should depreciate
to maintain price competitiveness. The rationale is based
on the assumption that changes in relative prices impact
consumer purchasing power and affect international
trade flows. Relative PPP theory provides a framework for
understanding the long-term relationship between
inflation differentials and exchange rate movements,
highlighting the role of inflation as a driver of exchange
rate adjustments.

5. Derivation of Purchasing Power Parity: The derivation of
Purchasing Power Parity (PPP) involves the estimation of
the equilibrium exchange rate based on the relative price
levels between two countries. PPP suggests that the
exchange rate should adjust to equalize the prices of
identical goods in different countries. The derivation
process considers the price levels of a representative
basket of goods and services in each country and
calculates the exchange rate that would make the
purchasing power equivalent. This is achieved by
dividing the price level of one country by the price level
of another country. The derivation of PPP provides a
theoretical foundation for understanding the link between
price levels, exchange rates, and purchasing power in
international markets.

6. Using PPP to Estimate Exchange Rate Effects: Using
Purchasing Power Parity (PPP) to estimate exchange rate
effects involves applying the concept to analyze the
potential impact of inflation on currency exchange rates.
PPP suggests that changes in relative price levels
between countries should be reflected in exchange rate
movements. By comparing the inflation rates of two
countries, it is possible to estimate the expected change
in the exchange rate. If one country has higher inflation
than another, its currency is expected to depreciate.
Conversely, a country with lower inflation may experience
currency appreciation. Estimating exchange rate effects
using PPP provides insights into the relationship
between inflation differentials and exchange rate
movements.

7. Testing the Purchasing Power Parity: Testing the
Purchasing Power Parity (PPP) involves empirical
analysis to assess whether the theory holds in practice.
Various statistical tests and econometric models are
used to evaluate the relationship between inflation and
exchange rates across different countries. These tests
examine whether changes in relative price levels are
associated with changes in exchange rates over time.
Researchers analyze historical data and employ
regression analysis, unit root tests, cointegration
analysis, and other econometric techniques to determine
the validity of PPP. Testing PPP helps to understand the
extent to which exchange rates adjust to inflation
differentials and provides insights into the effectiveness
of PPP as a theory in explaining exchange rate dynamics.

8. Why Purchasing Power Parity Does Not Occur: There are
several reasons why Purchasing Power Parity (PPP) does
not always occur in practice. One primary reason is the
presence of various barriers that hinder the free
movement of goods and services across borders, such
as tariffs, quotas, transportation costs, and trade
restrictions. Additionally, differences in taxes, non-
tradable goods, and services, as well as market
imperfections, can contribute to deviations from PPP.
Furthermore, factors like transaction costs, differential
productivity growth, and changes in consumer
preferences can impact relative prices and prevent the
equalization of purchasing power. These factors
collectively explain why PPP is not consistently observed
in the real world.

9. Purchasing Power Parity in the Long Run: Purchasing
Power Parity (PPP) in the long run refers to the concept
that exchange rates will eventually adjust to equalize the
prices of identical goods in different countries. Over time,
PPP suggests that countries with higher inflation rates
should experience depreciation in their currency, while
countries with lower inflation rates should see currency
appreciation. However, in the short run, factors such as
market frictions, trade barriers, and capital flows can
cause deviations from PPP. The long-run perspective of
PPP helps to understand the tendencies of exchange
rates to revert to their equilibrium values based on
relative price levels and inflation differentials across
countries.

11. Fisher Effect: The Fisher Effect is an economic theory
that posits a relationship between nominal interest rates,
inflation rates, and real interest rates. According to the
Fisher Effect, there is a direct link between inflation and
nominal interest rates. The theory suggests that when
inflation increases, nominal interest rates should also
rise to compensate lenders for the eroding purchasing
power of future money. Conversely, when inflation
decreases, nominal interest rates should decrease
accordingly. The Fisher Effect helps to understand the
dynamics between interest rates and inflation, guiding
policymakers, investors, and analysts in assessing the
impact of inflation on the economy and making informed
decisions regarding interest rates.

12. Using the IFE to Predict Exchange Rate Movements: The
International Fisher Effect (IFE) theory suggests that the
difference in nominal interest rates between two
countries should reflect the expected change in their
exchange rates. Using the IFE to predict exchange rate
movements involves analyzing interest rate differentials
to estimate the direction and magnitude of future
exchange rate changes. If one country has a higher
nominal interest rate than another, the IFE suggests that
its currency is expected to depreciate against the other
currency. By examining interest rate differentials,
investors and analysts can gain insights into potential
exchange rate movements and make predictions about
currency appreciation or depreciation. The IFE serves as
a tool to guide decision-making in international financial

13. Implications of the International Fisher Effect: The
International Fisher Effect (IFE) has several implications
for understanding the relationship between interest rates
and exchange rates. Firstly, it suggests that interest rate
differentials between countries are driven by expected
changes in their exchange rates. If a country is expected
to experience currency depreciation, it would require
higher nominal interest rates to compensate for the
expected loss of purchasing power. Secondly, the IFE
implies that real interest rates should be equalized across
countries in the long run, as exchange rate adjustments
compensate for any differences in inflation rates. Lastly,
the IFE provides a framework for predicting exchange
rate movements based on interest rate differentials,
aiding investors and policymakers in making informed

14. Derivation of the International Fisher Effect: The
derivation of the International Fisher Effect (IFE) involves
the relationship between nominal interest rates, inflation
rates, and expected exchange rate changes. The theory is
derived from the Fisher Effect, which states that nominal
interest rates adjust based on expected inflation rates.
The International Fisher Effect extends this concept by
considering the impact of interest rate differentials on
expected changes in exchange rates. The derivation
process involves analyzing the relationship between
interest rate differentials and inflation differentials to
estimate the expected change in the exchange rate. The
derivation of the IFE provides a theoretical framework for
understanding the link between interest rates, inflation,
and exchange rate movements in international finance.

15. Tests of the International Fisher Effect: Tests of the
International Fisher Effect (IFE) are empirical analyses
conducted to assess the validity and applicability of the
theory in explaining exchange rate movements. These
tests examine the relationship between interest rate
differentials and expected changes in exchange rates
across different countries. Researchers employ
econometric techniques, such as regression analysis, to
analyze historical data and determine the extent to which
interest rate differentials predict exchange rate
movements. By testing the IFE, analysts can evaluate the
effectiveness of interest rate differentials as predictors of
exchange rate changes, providing insights into the
dynamics of the foreign exchange market and assisting
in decision-making regarding currency investments and

16. Limitations of the International Fisher Effect: The
International Fisher Effect (IFE) has certain limitations
that affect its practical application. First, the IFE assumes
that interest rate differentials accurately reflect expected
exchange rate changes, but this may not always hold true
due to other factors influencing exchange rates, such as
market sentiment and geopolitical events. Second, the
IFE assumes perfect capital mobility, which may not be
realistic in the presence of capital controls or
restrictions. Third, the IFE does not account for short-
term speculative movements in exchange rates. These
limitations highlight the need for caution when relying
solely on the IFE for predicting exchange rate movements
and necessitate a comprehensive analysis of various
factors impacting currency markets.

17. International Fisher Effect Theory versus Reality: The
International Fisher Effect (IFE) theory provides a
framework for understanding the relationship between
interest rates and exchange rates based on inflation
differentials. However, in practice, the IFE often faces
challenges and may not consistently hold. Reality often
deviates from the theoretical predictions of the IFE due to
various factors, including market inefficiencies,
speculative behavior, government interventions, and
economic shocks. Additionally, the IFE assumes rational
expectations and perfect information, which may not
align with real-world dynamics. It is important to
recognize the limitations and discrepancies between IFE
theory and actual exchange rate behavior when using the
IFE as a guideline for decision-making in international

18. Implications of the IFE for Foreign Investors: The
International Fisher Effect (IFE) has implications for
foreign investors in their investment decisions involving
different currencies. Firstly, the IFE suggests that
investors can consider interest rate differentials as
indicators of potential exchange rate movements. Higher
interest rates in one country, relative to another, may
signal expectations of currency depreciation. Secondly,
foreign investors can utilize the IFE to assess the
potential impact of inflation differentials on real returns.
By considering inflation rates and interest differentials,
investors can evaluate the relative attractiveness of
investment opportunities in different countries. The IFE
provides insights into the relationship between interest
rates, inflation, and exchange rates, aiding foreign