Relationships among inflation and exchange rate

◦ 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

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

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.

Assume that PPP holds.

Over time, inflation occurs and the exchange rate adjusts to maintain PPP:

where Ph = home country’s price indexIh = home country’s inflation rate

Pf Pf (1 + If ) (1 + ef )where Pf = foreign country’s price index

If = foreign country’s inflation rateef = foreign currency’s % D in value

PPP holds Ph = Pf and

Ph (1 + Ih ) = Pf (1 + If ) (1 + ef )

Solving for ef : ef = (1 + Ih ) – 1(1 + If )

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

Absolute form of PPP:

“ ”:

price of similar products to two countries should be equal when measured in a common currency.

Acknowledges market imperfections

such as:

Rate of change in the prices of

products should be similar when

measured in a common currency.

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

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

(PPP)

Forward rate premium p

Interest rate differential ih – if

fh

f

h iii

ip 1

1

1

% in spot exchange rate ef

Inflation rate differential Ih – If fh

f

hf II

I

Ie 1

1

1

% in spot exchange rate ef

Interest rate differential ih – if fh

f

hf ii

i

ie 1

1

1