chapter 08testing the purchasing power parity theory
TRANSCRIPT
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
1/30
Relationships among Inflation,Interest Rates, and Exchange Rates
Relationships among Inflation,Interest Rates, and Exchange Rates
88Chapter Chapter
18.J. Gaspar: Adapted from Jeff Madura, International Financial Management
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
2/30
International Finance Theories (cont)
• Purchasing Power Parity (PPP): At equilibrium, thefuture spot rate of a foreign currency will differ (in%) from the current spot rate by an amount that
equals (in %) the inflation differential between thehome and foreign countries.
• International Fisher Effect (IFE): At equilibrium, the
future spot rate of a foreign currency will differ (in%) from the current spot rate by an amount thatequals (in %) the nominal interest rate differentialbetween the home and foreign countries
28.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
3/30
Chapter Objectives
To explain the purchasing power parity (PPP) andinternational Fisher effect (IFE) theories, and their
implications for exchange rate changes; and To compare the PPP, IFE, and interest rate parity
(IRP) theories.
38.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
4/30
Purchasing Power Parity (PPP)
• When a country’s inflation rate rises relative to thatof another country, decreased exports and
increased imports depress the high-inflationcountry’s currency.
• Purchasing power parity (PPP) theory attempts toquantify this inflation – exchange rate relationship.
48.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
5/30
Interpretations of PPP
• The absolute form of PPP is an extension of thelaw of one price. It suggests that the prices of the
same products in different countries should beequal when measured in a common currency.
• The relative form of PPP accounts for marketdistortions like transportation costs, tariffs, taxes,
and quotas. It states that the rate of pricechanges should be similar.
58.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
6/30
Rationale behind PPP Theory
Suppose U.S. inflation > U.K. inflation.
U.S. imports from U.K. and
U.S. exports to U.K.
Upward pressure is placed on the £ .
This shift in consumption and the £’s appreciationwill continue until
in the U.S.: priceU.K. goods priceU.S. goods
in the U.K.: priceU.S. goods priceU.K. goods68.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
7/30
Derivation of PPP
Assume that PPP holds.
Over time, as inflation occurs exchange rates adjusts tomaintain PPP:
Ph1 Ph0 (1 + I h )
Where Ph1
=home country’s price index, year-1 end I
h=home country’s inflation rate for the year
Pf1 Pf0 (1 + I f ) (1 + ef )where P
f = foreign country’s price index
I f
= foreign country’s inflation rate
ef
= foreign currency’s % in value
78.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
8/30
Derivation of PPP
PPP holds Ph1 = Pf1 and
Ph0
(1 + I h ) = Pf0 (1 + I f ) (1 + ef )
Solving for ef : ef = (1 + I h ) – 1
(1 + I f
)
I h
> I f e
f > 0 i.e. foreign currency appreciates
I h
< I f e
f < 0 i.e. foreign currency depreciates
Example: Suppose I U.S. = 9% and I U.K. = 5% .
TheneU.K. =
(1 + .09 ) – 1 = 3.81%(1 + .05 )
88.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
9/30
Simplified PPP Relationship
When the inflation differential is small, the PPP relationship canbe simplified as
ef I h – I f
Example: Suppose I U.S. = 9% and I U.K. = 5% .
Then eU.K. 9 – 5 = 4%
U.S. consumers: PU.S. = I U.S. = 9%
PU.K.
= I U.K.
+ eU.K.
= 9%
U.K. consumers: PU.K. = I U.K. = 5%
PU.S. = I U.S. – eU.K. = 5%
98.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
10/30
Graphic Analysis of Purchasing Power
Parity
PPP line
Inflation Rate Differential (%)home inflation rate – foreign inflation rate
% in the
foreigncurrency’sspot rate
-2
-4
2
4
1 3-1-3
Increasedpurchasing
power offoreigngoods
Decreasedpurchasing
power offoreigngoods
A
B
C
D
108.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
11/30
Testing the PPP Theory
Conceptual Test
• Plot actual inflation differentials and exchange rate
% changes for two or more countries on a graph.• If the points deviate significantly from the PPP line
over time, then PPP does not hold.
118.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
12/30
Testing the PPP Theory
Statistical Test
• Apply regression analysis to historical exchange rates
and inflation differentials:
ef
= a0 + a1 [ (1+ I h)/(1+ I f ) – 1 ] +
• Then apply t-tests to the regression coefficients. (Test
for a0 = 0 and a1 = 1.)
• If any coefficient differs significantly from what wasexpected, PPP does not hold.
128.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
13/30
Testing the PPP Theory
• Empirical studies indicate that the relationshipbetween inflation differentials and exchange ratesis not perfect even in the long run.
• However, the use of inflation differentials toforecast long-run movements in exchange rates issupported.
A limitation in the tests is that the choice of thebase period will affect the result.
138.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
14/30
Why PPP Does Not Occur
PPP does not occur consistently due to:
confounding effects
• Exchange rates are also affected by differences ininflation, interest rates, income levels, governmentcontrols and expectations of future rates.
a lack of substitutes for some traded goods
148.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
15/30
PPP in the Long Run
• PPP can be tested by assessing a “real” exchangerate over time.
• The real exchange rate is the actual exchange rateadjusted for inflationary effects in the two countries ofconcern.
• If the real exchange rate follows a random walk, itcannot be viewed as being a constant in the longrun. Then PPP does not hold.
158.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
16/30
The Big Mac Index
THE Big Mac Index was invented by The Economist in1986 as a lighthearted guide to whether currencies are attheir “correct” level. It is based on the theory of
purchasing-power parity (PPP), the notion that in the longrun exchange rates should move towards the rate thatwould equalize the prices of an identical basket of goodsand services (in this case, a burger) in any two countries.For example, the average price of a Big Mac in America
in January 2015 was $4.79; in China it was only $2.77 atmarket exchange rates. So the "raw" Big Mac index saysthat the yuan was undervalued by 42% at that time.
http://www.economist.com/content/big-mac-index
168.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
17/30
International Fisher Effect (IFE)
• According to the Fisher effect, nominal risk-freeinterest rates contain a real rate of return andanticipated inflation
in = ir + inflation
• If all investors require the same real return,differentials in interest rates may be due to
differentials in expected inflation.• Recall that PPP theory suggests that exchange
rate movements are caused by inflation ratedifferentials.
178.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
18/30
International Fisher Effect (IFE)
• The international Fisher effect (IFE) theorysuggests that currencies with higher interest rateswill depreciate because the higher nominal ratesreflect higher expected inflation.
• Hence, investors hoping to capitalize on a higherforeign interest rate should earn a return no higher
than what they would have earned domestically.
188.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
19/30
International Fisher Effect (IFE)
InvestorsResiding in
Japan
U.S.
Canada
Japan
U.S.Canada
Japan
U.S.
Canada
Japan
U.S.
Canada
Attempt toInvest in I h
3
33
6
6
6
11
11
11
%
I f
3
611
3
6
11
3
6
11
%
ef
0
– 3 – 8
3
0
– 5
8
5
0
%
if
5
813
5
8
13
5
8
13
%
Return inHome
Currency
5
55
8
8
8
13
13
13
%
I h
3
33
6
6
6
11
11
11
%
RealReturnEarned
2
22
2
2
2
2
2
2
%
198.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
20/30
Derivation of the IFE
• According to the IFE, E(r f), the expected effective
return on a foreign money market investment,should equal r
h, the effective return on a domestic
investment.
• r f
= (1 + if) (1 + e
f) – 1
if = interest rate in the foreign country
ef
= % change in the foreign currency’svalue
• r h
=ih
= interest rate in the home country
208.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
21/30
Derivation of the IFE
• Setting r f
= r h
: (1 + if ) (1 + ef ) – 1 = ih
• Solving for ef : ef =
(1 + ih ) _ 1(1 + if )
• ih > if ef > 0 i.e. foreign currency appreciates ih < if ef < 0 i.e. foreign currency depreciates
Example: Suppose iU.S. = 11% and iU.K. =12%.
TheneU.K. =
(1 + .11 ) – 1 = –.89% .(1 + .12 )
This will make r f = r h .
218.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
22/30
Derivation of the IFE
• When the interest rate differential is small, the IFErelationship can be simplified as
ef i
h _ i
f
• If the British rate on 6-month deposits were2% above the U.S. interest rate, the £ should
depreciate by approximately 2% over 6
months. Then U.S. investors would earn about
the same return on British deposits as they
would on U.S. deposits.
228.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
23/30
Graphic Analysis of the
International Fisher Effect
238.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
24/30
Graphic Analysis of the IFE
• The point of the IFE theory is that if a firmperiodically tries to capitalize on higher foreigninterest rates, it will achieve a yield that issometimes above and sometimes below thedomestic yield.
• On average, the yield achieved by the firm would
be similar to that achieved by another firm thatmakes domestic deposits only.
248.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
25/30
Tests of the IFE
• If actual interest rates and exchange rate changesare plotted over time on a graph, we can seewhether the points are evenly scattered on bothsides of the IFE line.
• Empirical studies indicate that the IFE theoryholds during some time frames. However, there is
also evidence that it does not hold consistently.
258.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
26/30
Tests of the International Fisher
Effect
268.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
27/30
Tests of the IFE
• To test the IFE statistically, apply regressionanalysis to historical exchange rates and nominalinterest rate differentials:
ef = a0 + a1 [ (1+ih)/(1+if ) – 1 ] +
• Then applyt-tests to the regression coefficients.(Test for a0 = 0 and a1 = 1.)
• IFE does not hold if any coefficient differssignificantly from what was expected.
278.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
28/30
Why the IFE Does Not Occur
• Since the IFE is based on PPP, it will not holdwhen PPP does not hold.
• In particular, if there are factors other than inflationthat affect exchange rates, exchange rates maynot adjust in accordance with the inflationdifferential.
288.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
29/30
Comparison of the IRP, PPP, and IFE
Theories
Exchange RateExpectations
Inflation RateDifferential
Forward RateDiscount or Premium
Interest RateDifferential
Purchasing
Power Parity (PPP)
Interest Rate Parity
(IRP)
Fisher
Effect
International
Fisher Effect (IFE)
298.
-
8/18/2019 Chapter 08Testing the Purchasing Power Parity Theory
30/30
Comparison of the IRP, PPP, and IFE
Theories
Interest rate parity
Forward rate premium p
Interest rate differential ih– i
f
f h f
h iii
i p
1
1
1
Purchasing power parity
% in spot exchange rate e f Inflation rate differential I
h– I
f
f h
f
h f I I
I
I e
1
1
1
International Fisher effect
% in spot exchange rate e f Interest rate differential i
h– i
f
f h f
h f ii
i
ie
1
1
1
308.