8

Relationships among Inflation,

Interest Rates, and Exchange Rates

CHAPTER Inflation rates and interest rates can have a significant impact on exchange
OBJECTIVES rates (as explained in Chapter 4) and therefore can influence the value of
The specific MNCs. Financial managers of MNCs must understand how inflation and
objectives of this interest rates can affect exchange rates so that they can anticipate how
chapter are to:
their MNCs may be affected. Given their potential influence on MNC
■ explain the values, inflation and interest rates deserve to be studied more closely.
purchasing power
parity (PPP) theory
and its implications
for exchange rate 8-1 PURCHASING POWER PARITY (PPP)
changes, In Chapter 4, the expected impact of relative inflation rates on exchange rates was dis-
■ explain the cussed. Recall from this discussion that when a country’s inflation rate rises, the demand
international Fisher for its currency declines as its exports decline (because of their higher prices). In addi-
effect (IFE) theory tion, consumers and firms in that country tend to increase their importing. Both of these
and its implications
forces place downward pressure on the high-inflation country’s currency. Inflation rates
for exchange rate
changes, and often vary among countries, causing international trade patterns and exchange rates to
adjust accordingly. One of the most popular and controversial theories in international
■ compare the PPP
finance is the purchasing power parity (PPP) theory, which attempts to quantify the
theory, the IFE
theory, and the
relationship between inflation and the exchange rate. This theory supports the notion
theory of interest developed in Chapter 4 about how relatively high inflation places downward pressure
rate parity (IRP), on a currency’s value, but PPP is more specific about the degree by which a currency
which was will weaken in response to high inflation.
introduced in the
previous chapter.
8-1a Interpretations of Purchasing Power Parity
There are two popular forms of PPP theory, each with its own implications.
Absolute Form of PPP The absolute form of PPP is based on the idea that, in the
absence of international barriers, consumers will shift their demand to wherever prices
are lowest. The implication is that prices of the same basket of goods in two different
countries should be equal when measured in a common currency. If there is a discrep-
ancy in the prices as measured by such a common currency, then demand should shift
so that these prices converge.
EXAMPLE If the same basket of goods is produced by the United States and the United Kingdom and if
the price in the United Kingdom is lower when measured in a common currency, then the
demand for that basket should increase in the United Kingdom and decline in the United
States. Both forces would eventually cause the prices of the baskets to match when measured in a
common currency. l

255

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256 Part 2: Exchange Rate Behavior

The existence of transportation costs, tariffs, and quotas render the absolute form of
PPP unrealistic. If transportation costs were high in the preceding example, then demand
for the baskets of goods might not shift as suggested. In that case, the discrepancy in
prices would continue.
Relative Form of PPP The relative form of PPP accounts for such market imper-
fections as transportation costs, tariffs, and quotas. This version acknowledges that these
imperfections make it unlikely for prices of the same basket of goods in different coun-
tries to be the same when measured in a common currency. However, this form of PPP
suggests that the rate of change in the prices of the those baskets should be comparable
when measured in a common currency (assuming that transportation costs and trade
barriers are unchanged).
EXAMPLE Assume that the United States and the United Kingdom trade extensively with each other and initially
have zero inflation. Now suppose that the United States experiences a 9 percent inflation rate while
the United Kingdom experiences a 5 percent inflation rate. Under these conditions, PPP theory sug-
gests that the British pound should appreciate by approximately 4 percent (the difference between
their inflation rates). Given British inflation of 5 percent and the pound’s appreciation of 4 percent,
U.S. consumers will have to pay about 9 percent more for British goods than they paid in the initial
equilibrium state. That value is equal to the 9 percent increase in prices of U.S. goods due to U.S.
inflation. The exchange rate should adjust to offset the differential in the two countries’ inflation
rates, in which case the prices of goods in the two countries should appear similar to consumers. l

8-1b Rationale behind Relative PPP Theory

The relative PPP theory is based on the notion that exchange rate adjustment is neces-
sary for the relative purchasing power to be the same whether buying products locally or
from another country. If that purchasing power is not equal, then consumers will shift
purchases to wherever products are cheaper until purchasing power equalizes.
EXAMPLE Reconsider the previous example but now suppose that the pound appreciated by only 1 percent in
response to the inflation differential. In this case, the increased price of British goods to U.S. consumers
will be approximately 6 percent (5 percent inflation and 1 percent appreciation in the British pound),
which is less than the 9 percent increase in the price of U.S. goods to U.S. consumers. We should there-
fore expect U.S. consumers to continue shifting their consumption to British goods. Purchasing power
parity suggests that this increased U.S. consumption of British goods by U.S. consumers would persist
until the pound appreciated by about 4 percent. Thus, from the U.S. consumer’s viewpoint, any level
of appreciation lower than this would result in lower British prices than U.S. prices.
From the British consumer’s viewpoint, the price of U.S. goods would have initially increased by
4 percent more than British goods. Hence British consumers would continue to reduce their imports
from the United States until the pound appreciated enough to make U.S. goods no more expensive
than British goods. The net effect of the pound appreciating by 4 percent is that the prices of U.S.
goods would increase by approximately 5 percent to British consumers (9 percent inflation minus
the 4 percent savings to British consumers due to the pound’s 4 percent appreciation). l

8-1c Derivation of Purchasing Power Parity

Assume that the price indexes of the home country (h) and a foreign country (f) are
equal. Now assume that, over time, the home country experiences an inflation rate of Ih
while the foreign country experiences an inflation rate of If. Because of this inflation, the
price index of goods in the consumer’s home country (Ph) becomes
P h ð1 þ I h Þ
The price index of the foreign country (Pf) will also change in response to inflation in
that country:

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 Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates 257

P f ð1 þ I f Þ
If Ih 4 If and if the exchange rate between the two countries’ currencies does not change,
then the consumer’s purchasing power is greater for foreign than for home goods. In this
case, PPP does not hold. If Ih 5 If and again the exchange rate remains unchanged,
then the consumer’s purchasing power is greater for home than for foreign goods. So
in this case, too, PPP does not hold.
The PPP theory suggests that the exchange rate will not remain constant but will
adjust to maintain the parity in purchasing power. If inflation occurs and the exchange
rate of the foreign currency changes, then the foreign price index from the home
consumer’s perspective becomes
P f ð1 þ I f Þð1 þ e f Þ
where ef represents the percentage change in the value of the foreign currency. According
to PPP theory, the percentage change in the foreign currency (ef) should be such that
parity is maintained between the new price indexes of the two countries. We can solve
for ef under conditions of PPP by setting the formula for the new price index of the
foreign country equal to the formula for the new price index of the home country:
P f ð1 þ I f Þð1 þ e f Þ ¼ P h ð1 þ I h Þ
Solving for ef then yields
P h ð1 þ I h Þ
1 þ ef ¼ ,
P f ð1 þ I f Þ
P h ð1 þ I h Þ
ef ¼ 1
P f ð1 þ I f Þ
Since Ph is equal to Pf (because price indexes were assumed to be equal in both countries)
the two terms cancel, which leaves
1 þ Ih
ef ¼ 1
1 þ If
This equality expresses the relationship (according to PPP) between relative inflation
rates and the exchange rate. Observe that if Ih 4 If then ef should be positive, which
implies that the foreign currency will appreciate when the home country’s inflation
exceeds the foreign country’s inflation. Conversely, if Ih 5 If then ef should be negative;
this implies that the foreign currency will depreciate when the foreign country’s inflation
exceeds the home country’s inflation.

8-1d Using PPP to Estimate Exchange Rate Effects

The relative form of PPP can be used to estimate how an exchange rate will change in
response to different inflation rates in two countries.
EXAMPLE Assume that the exchange rate is initially in equilibrium. Then the home currency experiences a
5 percent inflation rate while the foreign country experiences a 3 percent inflation rate. According
to PPP, the foreign currency will adjust as follows:

1 þ Ih
ef ¼ 1
1 þ If
1 þ .05
¼ 1
1 þ .03
¼ .0194, or 1.94% l

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258 Part 2: Exchange Rate Behavior

According to this example, the foreign currency should appreciate by 1.94 percent in
response to the higher inflation of the home country relative to the foreign country. If
that exchange rate change does occur, then the price index of the foreign country will be
as high as the index in the home country from the perspective of home country consumers.
Even though inflation is lower in the foreign country, appreciation of its currency pushes
the its price index upward from the perspective of home country consumers. When consid-
ering the exchange rate effect, price indexes of both countries rise by 5 percent from the
home country perspective. Thus, consumers’ purchasing power is the same for foreign
goods and home goods.
EXAMPLE This example examines the case where foreign inflation exceeds home inflation. Suppose that the
exchange rate is initially in equilibrium but that then the home country experiences a 4 percent
inflation rate while the foreign country experiences a 7 percent inflation rate. According to PPP,
the foreign currency will adjust as follows:

1 þ Ih
ef ¼ 1
1 þ If
1 þ .04
¼ 1
1 þ .07
¼ .028, or 2.8%

According to this example, then the foreign currency should depreciate by 2.8 percent in
response to the foreign country’s higher inflation relative to that of the home country. Even though
inflation is lower in the home country, depreciation of the foreign currency puts downward pressure
on its prices from the perspective of home country consumers. When considering the exchange rate
impact, prices of both countries rise by 4 percent. Thus, PPP still holds in view of the adjustment in
the exchange rate. l

The theory of purchasing power parity is summarized in Exhibit 8.1. Notice that
international trade is the mechanism by which the inflation differential is theorized to
affect the exchange rate. This means that PPP is more applicable when the two countries
of concern engage in extensive international trade with each other. If there is not much
trade between the countries, then the inflation differential will have little effect on that
trade and so the exchange rate should not be expected to change.
Using a Simplified PPP Relationship A simplified but less precise relationship
based on PPP is
ef  I h  I f
That is, the percentage change in the exchange rate should be approximately equal to the
difference in inflation rates between the two countries. This simplified formula is appro-
priate only when the inflation differential is small or when the value of If is close to zero.

8-1e Graphic Analysis of Purchasing Power Parity

Using PPP theory, we should be able to assess the possible impact of inflation on exchange
rates. Exhibit 8.2 is a graphic representation of PPP theory. The points on the graph
indicate that, if there is an inflation differential of X percent between the home and the
foreign country, then the foreign currency should adjust by X percent in response to that
inflation differential.
PPP Line The diagonal line connecting all these points together is known as the
purchasing power parity (PPP) line. Point A in Exhibit 8.2 represents our earlier example
in which the U.S. (considered the home country) and British inflation rates were assumed
to be 9 and 5 percent (respectively), so that Ih  If ¼ 4%. Recall that these conditions led

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 Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates 259

Exhibit 8.1 Summary of Purchasing Power Parity

Scenario 1

Local
Imports
Currency
Relatively Will
Should
High Increase;
Depreciate
Local Exports
by Same Degree
Inflation Will
as
Decrease
Inflation Differential

Scenario 2

Local
Imports
Currency
Relatively Will
Should
Low Decrease;
Appreciate
Local Exports
by Same Degree
Inflation Will
as
Increase
Inflation Differential

Scenario 3

No Impact Local
Local and
of Inflation Currency’s
Foreign
on Value Is
Inflation
Import or Not
Rate Are
Export Affected
Similar
Volume by Inflation

to the anticipated appreciation in the British pound of 4 percent, as illustrated by point A.

Point B reflects the scenario in which the U.K. inflation rate exceeds the U.S. inflation rate
by 5 percent, so that Ih  If ¼ 5%. This leads the British pound to depreciate by 5 per-
cent (point B). If the exchange rate does in fact respond to inflation differentials, as PPP
theory suggests, then the actual points should lie on or close to the PPP line.
Purchasing Power Disparity Exhibit 8.3 identifies areas of purchasing power
disparity. Any points that are off of the PPP line represent purchasing power disparity.
Suppose an equilibrium is followed by a change in the inflation rates of two countries.
If the exchange rate does not move as PPP theory suggests, then there is a disparity in
the purchasing power of consumers in those two countries.
Point C in Exhibit 8.3 represents a case where home inflation Ih exceeds foreign inflation
If by 4 percent. Yet because the foreign currency appreciated by only 1 percent in response
to this inflation differential, there is purchasing power disparity. That is, home country con-
sumers’ purchasing power for foreign goods has increased relative to their purchasing
power for the home country’s goods. The PPP theory suggests that such a disparity in

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260 Part 2: Exchange Rate Behavior

Exhibit 8.2 Illustration of Purchasing Power Parity

Ih – If (%)

PPP Line
A
4

% D in the Foreign
–4 –2 2 4 Currency’s Spot Rate

–2

–4
B

disparity purchasing power should exist only in the short run. Over time, as the home country con-
sumers take advantage of the disparity by purchasing more foreign goods, upward pressure
on the foreign currency’s value will cause point C to move toward the PPP line. All points
to the left of (or above) the PPP line represent more favorable purchasing power for foreign
goods than for home goods.
Point D in Exhibit 8.3 represents a case where home inflation is 3 percent below for-
eign inflation but the foreign currency has depreciated by only 2 percent. Once again,
there is purchasing power disparity: now the currency’s purchasing power for foreign
goods has decreased relative to its purchasing power for the home country’s goods. The
PPP theory suggests that the foreign currency in this example should have depreciated
by 3 percent in order to fully offset the 3 percent inflation differential. Since the foreign
currency did not weaken to this extent, home country consumers may cease to purchase
foreign goods. Such behavior would cause the foreign currency to weaken to the extent
anticipated by PPP theory, so point D would move toward the PPP line. All points to the
right of (or below) the PPP line represent greater purchasing power for home country
goods than for foreign goods.

8-1f Testing the Purchasing Power Parity Theory

The PPP theory provides an explanation of how relative inflation rates between two
countries can influence an exchange rate, and it also provides information that can be
used to forecast exchange rates.

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 Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates 261

Exhibit 8.3 Identifying Disparity in Purchasing Power

Ih – If (%)

PPP Line
C
Increased Purchasing
Power of Foreign Goods 3

1
% D in the Foreign
–3 –1 1 3
Currency’s Spot Rate
–1

D –3 Decreased Purchasing
Power of Foreign Goods

Simple Test of PPP A simple test of PPP theory is to choose two countries (such
as the United States and a foreign country) and compare the differential in their inflation
rates to the percentage change in the foreign currency’s value during several time
periods. Using a graph similar to Exhibit 8.3, we could plot each point representing the
inflation differential and exchange rate percentage change for each specific time period
and then determine whether these points closely resemble the PPP line as drawn in
Exhibit 8.3. If the points deviate significantly from the PPP line, then the percentage
change in the foreign currency is not being affected by the inflation differential in the
manner that PPP theory suggests.
This simple test of PPP is applied to four different currencies from a U.S. perspective
in Exhibit 8.4 (each graph represents a particular currency). The annual difference in
inflation between the United States and each foreign country is represented on the verti-
cal axis, while the annual percentage change in the exchange rate of each foreign cur-
rency (relative to the U.S. dollar) is represented on the horizontal axis. Each point on a
graph represents one year during the period 1982–2009.
Although each graph shows different results, some general comments apply to all four
of them. The percentage changes in exchange rates are typically much more pronounced
than the inflation differentials. Thus, it seems that exchange rates change to a greater
extent than PPP theory would predict. In some years, the currency actually appreciated
when its inflation was higher than U.S. inflation. Overall, the results in Exhibit 8.4 indi-
cate that, over the period assessed, the actual relationship between inflation differentials
and exchange rate movements is not consistent with PPP theory.

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262 Part 2: Exchange Rate Behavior

Exhibit 8.4 Comparison of Annual Inflation Differentials and Exchange Rate Movements for Four Major Countries

U.S. Inflation Minus Canadian Inflation (%) U.S. Inflation Minus Swiss Inflation (%)
30 30

20 20

10 10

% D in % D in
–30 –20 –10 10 20 30 Canadian $ –30 –20 –10 10 20 30 Swiss
Franc
–10 –10

–20 –20

–30 –30

U.S. Inflation Minus Japanese Inflation (%) U.S. Inflation Minus British Inflation (%)
30 30

20 20

10 10

% D in % D in
–30 –20 –10 10 20 30 Japanese –30 –20 –10 10 20 30 British
Yen Pound
–10 –10

–20 –20

–30 –30

Statistical Test of PPP A simplified statistical test of PPP can be developed by

applying regression analysis to historical exchange rates and inflation differentials (see
Appendix C for more information on regression analysis). To illustrate, let’s focus on
one particular exchange rate. The quarterly percentage changes in the foreign currency
value (ef) can be regressed against the inflation differential that existed at the beginning
of each quarter as follows:
 
1 þ I U.S.
e f ¼ a0 þ a1 1 þμ
1 þ If
Here a0 is a constant, a1 is the slope coefficient, and µ is an error term. Regression anal-
ysis would be applied to quarterly data to determine the regression coefficients. The
hypothesized values of a0 and a1 are 0 and 1, respectively. These coefficients imply that,
on average, for a given inflation differential there is an equal (offsetting) percentage

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 Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates 263

change in the exchange rate. The appropriate t-test for each regression coefficient
requires a comparison to the hypothesized value and division by the standard error
(s.e.) of the coefficient as follows:
Test for a0 ¼ 0 : Test for a1 ¼ 1 :
a0  0 a1  1
t¼ t¼
s.e. of a0 s.e. of a1
The next step is using the t-table is used to find the critical t-value. If either t-test
finds that the coefficients differ significantly from what is expected, then the relationship
between the inflation differential and the exchange rate is other than as stated by PPP
theory. However, there is controversy over the appropriate lag time (between the infla-
tion differential and the exchange rate) to use when making these calculations.
Results of Statistical Tests of PPP Numerous studies have been conducted to
statistically test whether PPP holds. Although much research has documented how high
inflation can weaken a currency’s value, evidence has also been found of significant
deviations from PPP. These deviations are less pronounced when longer time periods
are considered, but they remain nonetheless. As a result, relying on PPP to derive a fore-
cast of the exchange rate is subject to significant error, even for long-term forecasts.
Limitation of PPP Tests A limitation in testing PPP theory is that the results will
vary with the base period used. The base period chosen should reflect an equilibrium
position because subsequent periods are evaluated in comparison with it. If a base period
is used when the foreign currency was relatively weak for reasons other than high infla-
tion, then most subsequent periods might erroneously show higher appreciation of that
currency than predicted by PPP.

8-1g Why Purchasing Power Parity Does Not Hold

Purchasing power parity does not normally hold because of confounding effects and
because there are no substitutes for some traded goods. These reasons are explained
next.
Confounding Effects The PPP theory presumes that exchange rate movements
are driven completely by the inflation differential between two countries. Recall from
Chapter 4, however, that a currency’s spot rate is affected by several factors:
e ¼ f ðDINF, DINT, DINC, DGC, DEXPÞ
where
e ¼ percentage change in the spot rate
DINF ¼ change in the differential between U:S: inflation
and the foreign country’s inflation
DINT ¼ change in the differential between the U:S: interest rate
and the foreign country’s interest rate
DINC ¼ change in the differential between the U:S: income level
and the foreign country’s income level
DGC ¼ change in government controls
DEXP ¼ change in expectations of future exchange rates
Since exchange rate movements are not driven solely by ΔINF, the relationship between
the inflation differential and exchange rate movement cannot be as simple as the PPP
theory suggests.

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264 Part 2: Exchange Rate Behavior

EXAMPLE Assume that Switzerland’s inflation rate is 3 percent above the U.S. inflation rate. From this infor-
mation, PPP theory would suggest that the Swiss franc should depreciate by about 3 percent against
the U.S. dollar. Yet, if the government of Switzerland imposes trade barriers against some U.S.
exports, Switzerland’s consumers and firms will not be able to adjust their spending in reaction to
the inflation differential. Therefore, the exchange rate will not adjust as suggested by purchasing
power parity. l

No Substitutes for Traded Goods The idea behind PPP theory is that, as soon as
prices become relatively higher in one country, consumers in the other country will stop
buying imported goods and instead purchase domestic goods. This shift, in turn, affects
the exchange rate. However, if substitute goods are not available domestically then con-
sumers will probably not desist from buying imported goods.
EXAMPLE Reconsider the previous example in which Switzerland’s inflation is 3 percent higher than the U.S.
inflation rate. The U.S. consumers who do not find suitable substitute goods at home may continue
to buy the highly priced goods from Switzerland, in which case the Swiss franc may not depreciate
as PPP theory would predict. l

8-2 INTERNATIONAL FISHER EFFECT (IFE)

Along with PPP theory, another major theory in international finance is the interna-
tional Fisher effect (IFE) theory. It uses the difference in interest (rather than inflation)
rates to explain why exchange rates shift over time. Recall from Chapter 4 that a high
interest rate can attract a strong demand for a local currency and so may put upward
pressure on that currency’s value. However, the international Fisher effect theory offers
a counterargument about how interest rates affect exchange rates, and it uses PPP to
support that argument.

8-2a Fisher Effect

The first step in understanding the international Fisher effect is to recognize how a
country’s nominal (quoted) interest rate and inflation rate are related. This relation is
commonly referred to as the Fisher effect, named after the economist Irving Fisher. The
Fisher effect presumes that the nominal interest rate consists of two components: the
expected inflation rate and the real rate of interest. The real rate of interest is defined
as the return on the investment to savers after accounting for expected inflation, and it
is measured as the nominal interest rate minus the expected inflation rate. If the real rate
of interest in a country is constant over time, then the nominal rate of interest there
must adjust to changes in the expected rate of inflation.
EXAMPLE Suppose that inhabitants of the United States are willing to save money only if they can earn a real
interest rate of 2 percent. This means that their savings must grow by 2 percent more than the gen-
eral price level of products that savers might purchase in the future with their savings. If the
expected U.S. annual rate of inflation is 1 percent, then the one-year interest rate on a savings
deposit should be 3 percent in order to allow for a real interest rate of 2 percent.
As expected inflation in the United States changes over time, the nominal interest rate would
have to change as well in order to provide savers with a real interest rate of 2 percent. Suppose
economic conditions have led U.S. savers to believe that the expected annual rate of inflation is
now 4 percent instead of 1 percent. At the nominal interest rate of 3 percent, saving would be a
losing proposition because the prices of products for which consumers are saving increase more rap-
idly than their savings. If the nominal interest rate on deposits remained lower than expected infla-
tion, then the real interest rate would be negative; in this case, savers may be better off spending
their money now (and even borrowing, if necessary) in order to purchase products before prices

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 Chapter 8: Relationships among Inflation, Interest Rates, and Exchange Rates 265

increase. Thus savers are willing to save money only if the nominal interest rate on savings deposits
is 5 percent, which would allow for a 2 percent real rate of interest (after accounting for the
expected annual inflation of 3 percent). This means that financial institutions must increase their
deposit rate to 5 percent in order to attract savers.
Now assume that economic conditions change again, causing savers to expect that annual infla-
tion will be 6 percent over the next year. If the prevailing nominal interest rate of 5 percent did
not change, then savers would be unwilling to save money because prices are increasing faster than
the rates paid on savings deposit. Under these conditions, savers would be willing to save only if the
nominal one-year interest rate on deposits rises to 8 percent; that would allow for a real rate of
interest of 2 percent after accounting for the expected annual inflation of 6 percent. l

We cannot directly observe the expected inflation rate in a country. However, we can
use the Fisher effect to infer the expected inflation at any time once given both the exist-
ing nominal interest rate and the assumed real rate of interest at that time:

IF THE U.S. NOMINAL A ND I F TH E R EA L T H E N T H E EX P E C T E D

I N TER E ST R ATE I S INTEREST RATE IS INFLATION RATE IS

3% 2% 1%
5% 2% 3%

Because nominal one-year interest rates are publicly available for some countries, the
expected inflation rate of these countries can be derived using the Fisher effect and
assuming a real rate of interest.

8-2b Using the IFE to Predict Exchange Rate Movements

Two steps are required when using the international Fisher effect to predict exchange
rate movements between two countries. First, apply the Fisher effect to estimate the
expected inflation for each country. Second, rely on purchasing power parity theory to
estimate how the difference in expected inflation will affect the exchange rate.
Apply the Fisher Effect to Derive Expected Inflation per Country The
first step is to derive the expected inflation rates of the two countries based on the Fisher
effect’s claim that the nominal interest rate in two countries differs because of the differ-
ence in their expected inflation. By assuming that the real interest rate is the same in the
two countries, the difference between them in terms of the nominal interest rate is
completely attributed to the difference in their expected inflation rates. Thus the differ-
ence in expected inflation is equal to the difference in nominal interest rates between the
two countries, which means that expected inflation is higher in the country whose inter-
est rate is higher.
EXAMPLE Assume that the real rate of interest is 2 percent in both Canada and the United States, and assume
that the one-year nominal interest rate is 13 percent in Canada versus 8 percent in the United
States. According to the Fisher effect, the expected inflation rate over the next year in each
country is equal to the nominal interest rate minus the real rate of interest. For Canada, the
expected inflation rate is 13%  2% ¼ 11%; for the United States, it is 8%  2% ¼ 6%. Hence the dif-
ference in expected inflation between the two countries is 11%  6% ¼ 5%. Note that this difference
in expected inflation between the countries is equal to the difference in nominal interest rates
(13%  8% ¼ 5%) between them. l

Rely on PPP to Estimate the Exchange Rate Movement The second step
when using the international Fisher effect to predict movements in the exchange rate is
to determine via PPP how the exchange rate would change in response to the two coun-
tries’ expected inflation rates as calculated in the first step. As discussed previously, the

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