Chapter 8

Relationship among Inflation,

Interest Rate and Exchange Rate

1
 Objectives

1. Explain the purchasing power parity theory

and its implication for exchange rate changes.

2. Explain the international Fisher effect theory

and its implication for exchange rate changes

2
 Absolute form of PPP (Law of One Price)

•Prices of two similar products of two different countries

should be equal due to demand and exchange rate
adjustment.
•If a discrepancy in prices as measured by common
currency exist, demand should shift so that those prices
converge.
i.e. Prices of lychee
Singapore 1 unit = S$1
Malaysia 1 unit = RM3
Exchange rate & price of lychee
S$1= RM2.5
S$1/1 unit = RM?
S$1/S$1 X RM2.5 = RM2.5→demand would continue to change until price
converge 3
•Demand for Singapore lychee > demand for
Malaysian lychee
•Demand for S$ ↑
•S$ value ↑ and RM ↓
•New exchange rate i.e. S$1 = RM3
•Based on the new exchange rate, the price of
lychee in RM is :
Exchange rate & price of lychee
S$1= RM3
S$1/1 unit = RM?
S$1/S$1 X RM3 = RM3
→ because the price of Singapore lychee and
Malaysia lychee is equivalent, the demand for
Singapore lychee would cease to increase.
4
 Inflation rate

• What cause the price of similar products in different

countries to be different?
→inflation rate
• The price of lychee in Malaysia > price in Singapore due
to higher inflation rate in Malaysia as compared to in
Singapore.
• Also because inflation, ultimately we observe from the
example that RM value depreciate relative to Singapore
dollar (as describe by PPP).
• S$1 = RM2.5 to S$1 = RM3

5
 Forecasting % Change in Ex. Rate:
•The US experiences 9% inflation rate
•The UK experiences 5% inflation rate
•PPP suggest that the British Pound (£) should appreciate
(or US dollar should depreciate) by approximately 4%.

1  Ih
f  1
1  IF
Ih  home inflation(USA)
IF  foreign inflation(UK)
f  percentage change in foreign currency
6
 Calculation :

1  Ih
f  1
1  IF
Ih  9%(USA)
IF  5%(UK)
1  9%
f   1  0.038  3.08% ≈ 4%
1  5%
• positive f means that foreign currency (£)
should appreciate.

7
 Rule of thumb

Ih  IF  f     foreign currency appreciates

Ih  IF  f     foreign currency depreciates

Why when
Ih  USA   IF UK  ,British pound
appreciates?

8
 USA inflation = 9% > UK inflation = 5%

•Prices of goods in the US are 4% higher

compare to in the UK
•Purchase more of UK’ s goods
•Demand for British pound ↑,thus value of £↑
relative to US dollar
•Value of £ will increase up to 4%
•Once £ have increase in value to 4%,the
cost of buying £ will offset the gain from
buying UK goods for the US customer.

9
•After British pound (£) has appreciated to some
extent (level), the buying of UK product will stop.
•The impact of higher inflation level in the US is
no longer significant because people in the US
are indifferent either to buy goods in the US or in
UK as prices of goods are now relatively equal in
both countries .

10
Example 2

USA inflation = 1% < Germany inflation = 6%

Ih  IF  f     foreign currency depreciates

1  Ih
f  1
1  IF
Ih  1%(USA)
IF  6%(Germany)
1  1%
f   1  0.0471  4.71% ≈ -5%
1  6% 11
USA inflation = 1% > Germany inflation = 6%

•Prices of goods in Germany are 5% higher

compare to in the US
•Germany’s customer purchase more of US’ s
goods
•Demand for US$ ↑,thus value of US$↑ relative to
Dm (Dm ↓ in value).
•Value of Dm will decrease by 5%
•Once Dm value ↓ by 5%,the cost of buying US$ will
offset the gain from buying US goods by the
German customer.

12
•After $US dollar has appreciated to some extent
(level), the buying of US product will stop.
•The impact of higher inflation level in Germany
is no longer significant because people in
Germany are indifferent either to buy goods in
the US or in Germany as prices of goods are now
relatively equal in both countries .

13
 International Fisher Effect

Major Assumptions :

1. Interest rate is highly correlated with inflation rate

Inflation rate ↓ ↑
Interest rate ↓ ↑

2. ∆ inflation rate → ∆ interest rate

3. Country with relatively higher inflation rate will
experience currency depreciation.
4. Nominal rate int. rate = real interest rate + inflation rate
ie. 10% = 2% + 8%

14
 Interpretation of International Fisher Effect

Malaysia Singapore
Annual Nominal Int. 10% 13%
rate
Real rate 4% 4%
Inflation rate 6% 9%

• Assume you have invested S$1000 in Singapore bank

(total investment)
• The exchange rate at the time you make the
investment was S$1 = RM1

15
 1. Total accumulated investment at the nominal rate of 13%
in Singapore after 1 year
S$1000 X 1.13 = S$1130
2. After 1 year because of higher inflation rate experience by
Singapore, its currency depreciate in value.
S$1 = RM1 → S$1 = RM 0.97
3. After 1 year investing in Singapore, you brought back
your investment plus proceed to Malaysia :
S$1 = RM 0.97
S$1130 = RM ?
S$1130 / S$1 X RM 097 = RM 1096.10
4. Compare with the return of the investment was made in
Malaysia at 10% rate of return.

In Malaysia @ 10% RM 1000 X 1.10= RM1100

In Singapore @ 13% RM1096
16
 International Fisher Effect (IFE)

•The international Fisher Effect theory suggest

that currencies with higher interest rates will
depreciates because the higher nominal rates
reflect higher expected inflation.

•Hence, investor hoping to capitalize on a higher

foreign interest rate should earn a return no
higher than what they would have earned
domestically.

17
 How much the exchange rate should change in order
to offset any gain from interest rate differential?
1  Ih
f  1
1  IF
Ih  home inflation
IF  foreign inflation
f  percentage change in foreign currency
1  Ih
i.e. f  1
1  IF
Ih  10%(Malaysia)
IF  13%(Singapore)
1  10%
f   1  0.0275  2.75% ≈ -3%
1  13%
- Singapore dollar should depreciate by 3% ~ 4% relative
18
to RM.
 Example 3

1  Ih
f  1
1  IF
Ih  10%(Malaysia)
IF  8%(Indonesia)
1  10%
f   1  0.0185  1.85% ≈ 2%
1  8%

•Indonesia currency should appreciate by 2% against

Malaysia (RM).
•Under these conditions, any Indonesian investors
investing in Malaysia would earn a return similar to
any Indonesia. Why?
19
Assume :

Malaysia Indonesia
Nominal Interest rate 10% 8%

Exchange rate : RM1 = 100 Rupiah (t=0)

RM1 = 98 Rupiah (t=1)
Pak Mustar has 100,000 Rupiah available for investment.

20
1. Exchange 100,000 Rupiah to RM :
RM1 = 100 Rupiah
RM? = 100,000 Rupiah
100,000 / 100 X RM1 = RM1000
2. Total investment accumulated after 1 year in Malaysia @ 10 %
RM1000 X (1.10) = RM1100
3. Due to international Fisher effect RM ↓ by 2% (10% - 8%).
New exchange rate → RM 1 = 98 Rupiah
4. Remit accumulated investment to Indonesia at new exchange
rate.
→RM1100 / RM1 X 98 Rupiah = 107,800 Rupiah.
5. Compare to accumulated investment if it took place in
Indonesia
invest in Indonesia @ 8%
→100,000 Rupiah X (1.08) = 108,000 Rupiah
invest in Malaysia @ 10% = 107,800 Rupiah

Due to international Fisher effect, Indonesia investor would

earn about the same return on Malaysia securities as they21
would on Indonesia securities.