INTERNATIONAL FINANCIAL SYSTEM

ROLE OF INFLANTION Inflation is the result of the supply and demand for currency. If
additional money is injected into an economy that is not producing greater output, people will
have more money to spend on the same amount of products as before. As growing demand
for products outstrips stagnant supply, prices will rise and devour any increase in amount of
money that consumers have to spend. Therefore, inflation erodes people’s purchasing power.

Impact of Money-Supply Decision because of the damaging effect of inflation, governments

try to manage the supply of and demand for their currencies. They do this through the uses of
two types of policies designed to influence a nation’s money supply. Money policy refers to
activities that directly affect a nation’s interest rates of money supply. Selling government
securities reduces a nation’s money supply because investors pay money to the government’s
treasury to acquire the securities. Conversely, when the government buys its own securities
on the open market cash is infused into the economy and the money supply increases.

Fiscal policy involves using taxes and government spending into influence the money
supply indirectly. For example, to reduce the amount of money in the hands of consumers,
governments increase taxes ---people are forced to pay money to the government coffers.
Conversely, lowering taxes increases the amount of money in the hands of consumers.
Governments can also step up their own spending activities to increase the amount of money
circulating in the economy or cut government spending to reduce it.

Impact of Unemployment and Interest Rates Many industrialized countries are very
effective at controlling inflation. Some economists claim that international competition is
responsible for keeping inflation under control. They reason that global competition and the
mobility of companies to move anywhere that cost are lowest keeps a lid on wages. Because
wages are kept under control, companies do not raise prices on their products, thus containing
inflation.
Other key factors in the inflation equation are a country’s unemployment and interest
rates. When unemployment rates are low, there is a shortage of labor, and employers pay
higher wages to attract employees. To maintain reasonable profit margins with higher labor
costs, they then usually raise the prices of their products, passing the cost of higher wages on
to the consumer and causing inflation.
 Interest rates (discussed in detail later in this chapter) affect inflation because they
affect the cost of borrowing money. Low interest rates encourage people to take out loans to
buy items such as homes and cars and to run up debt on credit cards. High interest rates
prompt people to cut down on the amount of debt they carry because higher rates mean larges
monthly payments on debt. Thus one way to cool off and inflationary economy is to raise
interest rates. Raising the cost of debt reduces consumers spending and makes business
expansion more costly.

How Exchange Rates Adjust to Inflation An important component of the concept of

purchasing power parity is that exchange rates adjust to different rates of inflation in different
countries. Such adjustment is necessary to maintain purchasing power parity between nations.
Suppose that at the beginning of the year the exchange rate between the Mexican peso and
the U.S. dollar is 8 pesos/$ (or $0.125/peso). Also suppose that inflation is pushing consumer
prices higher in Mexico at an annual rate of 20 percent, whereas price are rising just 3 percent
per year in the United States. To find the new exchange rate (Et) at the end of the year, we use
the following formula:
Et = Eb (1 + i1)/(1 + i2)
where Eb is the exchange rate at the beginning of the period, i1 is the inflation rate in
country 1, and i2 is the inflation rate in country 2. Plugging the numbers for this example into
the formula, we get:
Et = 8pesos/$ [(1 + 0.20)/(1 + 0.003)] = 9.3pesos/$

It is important to remember that because change rate is in e numerator of the

exchange rate is in pesos, the inflation rate for Mexico must also be placed in the numerator
for the ratio of inflation rates. Thus we see that the exchange rate adjusts from 8 pesos/$ to
9.3 peosos/$ because of the higher inflation rate in Mexico and the corresponding change in
currency value. Higher inflation in Mexico reduces the number of U.S. dollars that a peso
will buy and increases the number of pesos that a dollar will buy and increases the number of
pesos that a dollar will buy. In other word, whereas it had cost only 8 pesos to buy a dollar at
the beginning of the year, it now costs 9.3 pesos.
In our example, companies based in Mexico must pay more in pesos for any supplies
bought from the United States. But U.S. companies will pay less, in dollar terms, for supplies
bought from Mexico. Also, tourists from United States would be delighted, as vacationing in
Mexico become less expensive, but Mexico will find the cost of visiting the United States
more expensive.
 This discussion illustrates at least one of difficulties facing countries with high rates
of inflation. Both consumers and companies in countries experiencing rapidly increasing
price see their purchasing power eroded. Developing countries and countries in transition are
those most often plagued by rapidly increasing prices.

ROLE OF INTEREST RATES To see how interest rates affect exchange rates between two
currencies, we must first review the connection between inflation and interest rates within a
single economy. We distinguish between two types of interest rates: real interest rates and
nominal interest rates. Let’s say that your local bank quotes you in interest rate on a new car
loan. That rate is the nominal interest rate, which consist of the real interest rate plus an
additional charge for inflation. The reasoning behind this principle is simple. The lender must
be compensated for the erosion of its purchasing power during the loan period caused by
inflation.

Fisher Effect Suppose your bank lends you money to buy a delivery van for your home-
based business. Let’s say that, given your credit-risk rating, the bank would normally charge
you 5 percent annual interest. But if inflation is expected to be 2 percent over the next year,
your annual rate of interest will be 7 percent: 5 percent real interest plus 2 percent to cover
inflation. This principle that relates inflations to interest rates is called the Fisher effect—the
principle that the nominal interest rate is the sum of the real interest rate and the expected rate
of inflation over a specific period. We write this relation between inflation and interest rate
as:
Nominal Interest Rate = Real Interest Rate + Inflation Rate

If money were free from all controls when transferred internationally, the real rate of
interest should be the same in all countries. To see why this is true, suppose that real interest
rates are 4 percent in Canada and 6 percent in the United States. This situation creates an
arbitrage opportunity: Investors could borrow money in Canada at 4 percent, lend it in the
United States at 6 percent, and earn a profit on the 2 percent spread in interest rates. If enough
people took advantage of this opportunity, interest rates would go up in Canada, where
demand for money would become heavier, and down in the United States, where the money
supply was growing again, the arbitrage opportunity would disappear because of the same
activities that made it a reality. That is why real interest rates must actually remain equal
across countries.
 We saw earlier the relation between inflation and exchange rates. The fisher effect
clarifies the relation between inflation and interest rates. How, let’s investigate the relation
between exchange rates and interest rates. To illustrate this relation, we refer to the
international fisher effect—the principle that a different in nominal interest rates supported by
two countries’ currencies will cause an equal that opposite charge is their spot exchange
rates. Recall from Chapter 9 that the spot rate is the rate quarrel for delivery of the traded
currency within two business days.
Because real interest rates are authentically equal across countries, any difference in
interest rates in two countries is must to different expected rate of inflation. A country that is
experiencing inflation higher than that of another country should see the value of its currency
fall. If so, the exchange rate must be adjusted to reflect this change in value. For example,
suppose nominal interest rates are 5 percent in Australia and 3 percent in Canada. Expected
inflation in Australia, then, is 2 percent higher than in Canada. The international Fisher effect
predicts that the value of the Australian dollar will fall try 2 percent against the Canadian
dollar.

EVALUATING PURCHASING POWER PARTY Purchasing power parity is better at

predicting long term exchange rates (more than 10 years), but accurate forecasts of short-term
rates are most beneficial to international managers. Even short-term plans must assume
certain things about future economic and political conditions in different countries, including
added cost, trade barriers, and investor psychology.

Impact of Added Costs There are many possible reasons for the failure of PPP to predict
exchange rates accurately. For example, PPP assumes no transportation costs. Suppose that
the same basket of goods costs $100 in the United States and 950 kroner ($150) in Norway.
Seemingly, one could make a profit through arbitrage by purchasing these goods in the
United States and selling them in Norway. However, if it costs another $60 to transport the
goods to Norway, the total cost of the good one they arrive in Norway will be $160. Thus no
shipment will occur. Because on arbitrage opportunity exist after transportation cost are
added, there will be no leveling of prices between the two markets and the price discrepancy
will persist. Thus even if PPP predicts that the Norwegian krone is overvalued, the effect of
transportation costs will keep the dollar/krone exchange rate from adjusting. In a world in
which transportation costs exist, PPP does not always contently predict shifts in exchange
rates.
Impact of Trade Barriers PPP also assumes no barriers to international trade. However,
such barriers certainly do exist. Governments establish trade barriers for many reasons,
including helping domestic companies remain competitive and preserving jobs for their
citizens. Suppose the Norwegian government in our earlier example imposes a 60 percent
tariff on the $100 basket of imported goods or makes its importation illegal. Because no
leveling of prices or exchange rate adjustment will occur, PPP will fail to predict exchange
rates accurately.

Impact of Business Confidence and Psychology Finally, PPP overlooks the humans aspect
of exchange rates—the role of people’s confidence and beliefs about a nation’s economy and
the value of its currency. Many countries gauge confidence in their economies by conducting
a business confidence survey. The largest survey of its kind in Japan is called the tankan
survey. It gauges business confidence four times each year among 10,000 companies.
Investor confidence in the value of currency plays an important role in determining its
exchange rate. Suppose several currency traders believe that the Indian rupee will increase in
value. They will buy Indian rupees at the current prices, sell them if the value increase, and
earn a profit. However, suppose that all traders share the same belief and all follow the same
course of action. The activity of the traders themselves will be sufficient to push the value of
the Indian rupee higher. It does not matter why traders believed the price would increase. As
long as enough people act on a similar belief regarding the future value of a currency, its
value will change accordingly.
That is why nations try to maintain the confidence of investors, businesspeople, and
consumers in their economies. Lost confidence causes companies to put off investing in new
products and technologies and to delay the hiring of additional employees. Consumers tend to
increase their savings and not increase their debts if they have lost confidence in an economy.
These kinds of behaviors act to weaken a nation’s currency.
Such large discrepancies between a currency’s exchange rate on currency markets and
the rate predicted by the Big Mac index are not surprising. For one thing, the selling price of
food is affected by subsides for agricultural products in most countries. Also, a Big Mac is
not a “traded” product in the sense that one can buy Big Macs in low-priced countries and
sell them in high-priced countries. Prices can also be affected because Big Macs are subject
to different marketing strategies in different countries. Finally, countries impose different
levels of sales tax on restaurant meals.
 The drawbacks of the Big Mac index reflect the fact that applying the law of one price
to a single product is too simplistic a method for estimating exchange rates. Nonetheless,
academic studies find that currency values tend to change in the direction suggested by the
Big Mac index.

Purchasing Power Parity

We introduce the concept of purchasing power parity in Chapter 4 when we discussed
economic development. This concept is also useful in determining at what level an exchange
rate should be. Recall that purchasing power parity (PPP) is the relative ability of two
countries’ currencies to buy the same “basket” of goods in those two countries. Thus,
although the law of one price holds for single products, PPP is meaningful only when applied
to a basket of goods. Let’s look at an example to see why this is so.
Suppose 650 baht in Thailand will buy a bag of groceries that cost $30 in the United
States. What do these two numbers tell us about the economic conditions of people in
Thailand as compared with people in the United States? First, they help the p us compare the
purchasing power of a Thai consumer with that of a consumer in the United States. But the
question is: Are Thai consumers better off or worse off than their counterparts in the United
States? To address this question, suppose the GNP per capita of each country is as follow:
Thai GNP/capita = 122,277 baht
U.S. GNP/capita = 26.980 dollars
Suppose also the exchange rate between the two currencies is 41.45 baht = 1 dollar.
With this figure, we can translate 122,277 baht into dollar: 122,277  41.45 = 2.950. we can
now restate our question: Do prices in Thailand enable a Thai consumer with $2,950 to buy
more or less than a consumer in the United States with $26.980?
We already know that 650  30 = 21.67 baht per dollar. Note that, whereas the
exchange rate on currency markets is 41.45 bath/$, the purchasing power parity rate of the
baht is 21.67/$. Let’s now use this figure to calculate a different comparative rate between the
two currencies. We can no recalculate Thailand’s GNP per capita at PPP as follows: 122,277
 21.67 = 5,643. Thai consumers on average are not nearly as affluent as their counterparts in
the United States. But when he consider the goods and services that they can purchase with
their baht—not the amount of U.S. dollars that they can buy—we see that a GNP per capita
at PPP of $5.643 more accurately portrays the real purchasing power of Thai consumers.
Our new calculation considers price levels in adjusting the relative values of the two
currencies. In the context of exchange rates, the principle of purchasing power parity can be
interpreted as the exchange rate between two nations’ currencies that is a equal to the ratio
of their price levels. In other words, PPP tells us that a consumer in Thailand needs 21.67
units (not 42.45)of Thai currency to buy the same amount of products as a consumer in the
United States can buy with one dollar.
As we see in this example, the exchange rate at PPP (21.67/$) is normally different
form the actual exchange rate in financial markets (41.45/$). Economic forces, says PPP
theory will push the actual market exchange rate toward that determined by purchasing power
parity. If they do not, arbitrage opportunities will arise. Purchasing power parity holds for
internationally traded products that are not restricted by trade barriers and that entail few or
no transportation cost. To earn a profit, arbitrageurs must be certain that the basket of goods
purchased in the low-cost country would still be lower-priced in the high-cost country after
adding transportation costs, tariffs, taxes, and so forth. Let’s now see what impact inflation
and interest rates have on exchange rates and purchasing power parity.