Relationships among

Inflation, Interest Rates,

and Exchange Rates
Purchasing Power Parity
When a country’s inflation rises, the demand for its currency declines as its exports
decline (due to their higher prices). Furthermore, since goods in the country are
expensive there is high levels of imports. Both forces put downward pressure on the
currency.
One of the popular and yet controversial theories of international finance is the
purchasing power parity (PPP) theory, which attempts to quantify the relationship
between inflation and the exchange rate.

Interpretations of Purchasing Power Parity

There are two forms of PPP theory:

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 discrepancy in prices in the common currency, demand should shift so
that both prices are equal.
However, the existence of transportation costs, tariffs, and quotas makes absolute
form of PPP unrealistic.

Relative Form of PPP

The relative form of PPP accounts for market imperfections such as transportation
costs, tariffs, and quotas.
This version states that due to these imperfections, the prices of the same basket of
products in different countries are unlikely to be the same when measured by a
common currency.

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However, this form of PPP suggests that the rate of change in the prices of those
baskets should be comparable when measured in a common currency (holding market
imperfections constant).
Example
For instance, assume the U.K. and U.S. (home country) trade with each other.
The U.S. experiences 9% inflation, while the U.K. experiences 5% inflation. How
should the exchange rates adjust under relative PPP theory?
Relative PPP suggests that the GBP must appreciate by around 4% (the difference in
inflation rates). Then, when the U.K. has 5% inflation and 4% currency appreciation,
the U.S. consumers who wish to buy U.K. products have to pay around 9% more than
they originally would have paid. This is similar to the 9% inflation in the U.S. Thus,
prices of goods in both countries seem equally expensive for U.S. customers.

Rationale behind Relative PPP Theory

The relative PPP theory is based on the notion that exchange rate adjustment is
necessary for the relative purchasing power to be the same whether you are buying
products locally or from another country.
If purchasing power is not equal, consumers will buy from the cheaper country until
purchasing power equalises.

Example
Continuing the previous U.K.-U.S. example, suppose the GBP only appreciated
1% in response to the interest rate differential. How will this impact consumption
pattern in U.S. and U.K.?
In this case, the increased price of British products to U.S. customers will be around
6% (5% inflation in U.K. plus 1% GBP appreciation), which is far less than the U.S.
inflation of 9%. We can, therefore, expect U.S. customers to shift their purchases to
British products.
PPP suggests that the increased consumption of British products from U.S. customers
will continue until the GBP appreciates by about 4%. From a U.S. customer’s
perspective, any appreciation of the GBP below 4% will make U.K. products cheaper
than U.S. products.
From a British customer’s perspective, the price of U.S. products will have increased
by around 4% more than British products. Thus, they will reduce imports from the U.S.
until the GBP appreciates enough to make U.S. product prices equal to British
products. So, they will expect the GBP to rise by 4%. The net effect will be a 5% rise
in U.S. prices for British customers (9% U.S. inflation minus 4% cost saving as the
GBP appreciates).

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Derivation of Purchasing Power Parity
Note that knowledge on this derivation is not essential, but useful to understand the
reasoning behind PPP.

Assume that the price index 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 inflation rate is at If. Because of this inflation, the price index of
products in the home country (Ph) becomes
𝑃 (1 + 𝐼 )
The price index in the foreign country (Pf) becomes
𝑃 (1 + 𝐼 )

If Ih > If and if the exchange rate between the two countries’ currencies do not change,
then the consumer purchasing power is greater in the foreign country. In this case,
PPP does not hold.
If Ih < If and exchange rate remains unchanged, then the consumer purchasing power
is greater in the home country. Again, PPP does not hold.
As per PPP theory, exchange rate will not remain constant. It will adjust to make
purchasing power equal in both countries.
If inflation occurs, and the exchange rate of the foreign currency changes, then the
foreign price index, from the home country’s perspective becomes

𝑃 1+𝐼 1+𝑒

(ef = is the percentage change in the value of foreign currency)

According to PPP theory, ef should be such that parity is maintained between the new
price indexes of the two countries.
We can solve for ef under PPP conditions by making the price index of the foreign
country equal to the price index of the home country.

𝑃 1+𝐼 1+𝑒 = 𝑃 (1 + 𝐼 )

Solving for ef:

𝑃 (1 + 𝐼 )
1+𝑒 =
𝑃 1+𝐼

𝑃 (1 + 𝐼 )
𝑒 = −1
𝑃 1+𝐼

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Because Ph is equal to Pf (price indexes were assumed equal in both countries), both
terms are cancelled out leaving:
1+𝐼
𝑒 = −1
1+𝐼

Observe that if:

Ih > If, then ef must be positive, which means foreign currency will appreciate when
home country inflation is higher than foreign country inflation.
Ih < If, then ef must be negative, meaning foreign currency will depreciate when home
country inflation is lower than the foreign country inflation.

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.
Example:
Assume the exchange rate is initially at equilibrium. Then the home currency
experiences 5% inflation and foreign inflation is 3%. What will be the exchange
rate adjustment as per PPP?
1+𝐼
𝑒 = −1
1+𝐼

1 + 5%
𝑒 = −1
1 + 3%

𝑒 = 1.94%

Accordingly, the exchange rate must rise 1.94%. When this happens, the foreign
prices seem as expensive as the home prices (foreign inflation plus exchange rate
appreciation). That is, home inflation is 5%, and foreign price rise is also around 5%
(= 3% foreign inflation + 1.94% currency appreciation).
Example:
Now assume exchange rate is at equilibrium, and home country experiences 4%
inflation while foreign inflation is 7%. What will the exchange rate adjustment as
per PPP?
1+𝐼
𝑒 = −1
1+𝐼

1 + 4%
𝑒 = −1
1 + 7%

𝑒 = −2.8%

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Accordingly, the exchange rate must drop 2.8%. When this happens, the foreign prices
seem as expensive as the home prices (foreign inflation less exchange rate
depreciation). That is, home inflation is 4%, and foreign price rise is also around 4%
(= 7% foreign inflation – 2.8% currency depreciation).
This is illustrated below. Note that international trade is the mechanism by which the
inflation differential is theoretically supposed to affect the exchange rate. That is, for
PPP to be strongly applicable, the two countries must engage in high levels of trade.

Using a Simplified PPP Relationship

A simple, yet less precise, relationship based on PPP is:
𝑒 ≈𝐼 −𝐼

This is appropriate when the inflation rate differential is small, or If is close to zero.

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Graphical Analysis of Purchasing Power Parity
Using PPP theory, we should be able to assess the possible impact of inflation on
exchange rates.
The below illustration is a graphical illustration of PPP.

The graph indicates that, if there is an inflation differential of X% between the home
country and the foreign country, then the foreign exchange rate should also adjust by
X%.

PPP Line
The diagonal line connecting all points where the inflation rate differential equals the
exchange rate change, is known as the purchasing power parity line.
Point A represents a situation where the U.S. (home country) and British inflation rates
are 9% and 5%, respectively, so that Ih – If = 4%. We discussed this example earlier
and identified that the GBP must appreciate 4%.
Point B is where the U.K. inflation exceeds the U.S. inflation by 5% as discussed in a
previous example. We identified that, in this case, the GBP must depreciate by 5%

Purchasing Power Disparity

Any points that are off of the PPP line represent purchasing power disparity.
If the exchange rate does not move as PPP theory suggests, then there is a disparity
in the purchasing power of consumers in the two countries.

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Point C represents where home currency inflation Ih exceeds foreign currency inflation
If by 4%. Yet, because the foreign currency appreciated by only 1%, there is
purchasing power disparity. That is, home consumers purchasing power of foreign
products has increased compared to their purchasing power of home products.
However, theory also states that this is only short-term as with more demand for
foreign currency to buy foreign products by the home country, the foreign currency’s
value will appreciate, causing point C to move towards the PPP line.
Point D represents where home inflation is 3% less than foreign inflation, but the
foreign exchange rate has depreciated by only 2%. Now, the home consumer’s
purchasing power of foreign products has declined more compared to the decline in
purchasing power for home products. Again, this is short-term, as home consumers
stop buying foreign products which puts downward pressure on the foreign currency
and point D will move towards the PPP line.

Testing the Purchasing Power Parity Theory

The PPP theory provides information that can be used to forecast exchange rates.

Simple Test of PPP

A simple test of PPP theory is to choose two countries (the U.S. as the home country
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.
We can plot the data points on a graph similar to the PPP line graph drawn earlier and
see if the data points resemble the PPP line. If the points deviate significantly from the
PPP line, then the percentage in foreign currency is not being affected by the inflation
differential as per PPP theory.
The simple test is applied to four currencies (with U.S. as the home currency) below,
and each point represents data from one year from 1984 – 2014.

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Although each graph shows different results, generally, the percentage changes in
exchange rates are stronger than the inflation rate differentials.
The graphs show that practically, the inflation differential and exchange rate
relationship is not as solid as in theory.

Statistical Test of PPP

A simple statistical test of PPP can be developed by running a regression analysis to
historical exchange rate rates and inflation differentials.

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 cam weaken a currency’s
value, evidence has also been found for significant deviation from PPP theory.
These deviations are more pronounced when longer time periods are concerned,
hence the forecasting of long-term exchange rate is subject to significant error.

Limitations 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 by comparing PPP to this base period.
If the foreign currency was weak for reasons other than high inflation in the base
period, then most subsequent periods might erroneously show higher appreciation of
that currency than predicted by PPP.

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Does Purchasing Power Parity Exist?
PPP does not normally exist due to confounding effects and because there are no
substitutes for some traded products.

Confounding Effects
The PPP theory presumes that exchange rate movements are driven completely on
the inflation differential between two countries. However, a currency’s spot rate is
affected by a multitude of factors:
𝑒 = 𝑓(∆𝐼𝑁𝐹, ∆𝐼𝑁𝑇, ∆𝐼𝑁𝐶, ∆𝐺𝐶, ∆𝐸𝑋𝑃)
Where:
e = percentage change in the spot rate
ΔINF = change in the differential between U.S. inflation and the foreign
country’s inflation
ΔINT = change in the differential between U.S. interest rate and the
foreign country’s interest rate
ΔINC = change in the differential between U.S. income level and the
foreign country’s income level
ΔGC = change in government controls
ΔEXP = change in expectations of future exchange rates
Because of this, the relationship between inflation differential and exchange rate
cannot be as simple as the PPP theory suggests.
For instance, assume that Switzerland’s inflation is 3% more than the U.S. inflation.
From this information, PPP theory would state that the Swiss franc (CHF) should
depreciate by 3% against the USD. Yet if the government of Switzerland imposes trade
barrier on some U.S. products, Switzerland’s consumers will not be able to adjust their
spending in reaction to the inflation differential. Therefore, exchange rates won’t adjust
according to PPP theory.

No Substitutes for Traded Products

The idea behind PPP theory is that, as soon as prices become high in one country,
consumers in the other country will stop buying imported products and instead
purchase domestics products, which are substitutes.
This, in turn, affects the exchange rate.
However, if substitutes are not available locally, consumers will have to keep buying
imported products.
For instance, when oil prices rise in the market, consumers in the home country cannot
stop importing oil as there may be not substitutes locally. Thus, demand and supply
for foreign currency may not change as stated by PPP theory.

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International Fisher Effect
The international Fisher effect (IFE) theory offers a specific relationship between the
differential in nominal interest rates of two countries and the exchange rate movement.
It suggests:
1) How each country’s nominal interest rate can be used to derive its expected
inflation rates, and
2) How the difference in inflation rates between two countries signals an expected
change in the exchange rate

Deriving a Country’s Expected Inflation Rate

The Fisher effect, as put forward by economist Irving Fisher in 1930, defined the
relationship between the nominal (quoted) interest rate and the expected inflation rate.
Thus, in order to attract savers, the Fisher effect holds that banks must quote an
interest rate higher than the expected inflation of the country.
𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = (𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒) > 0
If we rearrange these terms:
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 + 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

Thus, if real interest rate required was 2%, and inflation was expected to be around
1%, then banks should, theoretically, offer savers a rate of 3%:
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 + 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 2% + 1%
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 3%

Now, if we assume real interest rate is constant, then any change in inflation would
change the nominal interest rate quoted by banks.
However, we cannot observe the inflation rate a country expects, since that would
mean getting the opinion of all the citizens in the country. But we can rearrange the
formula to derive the inflation expectation:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 − 𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

Thus, the expected inflation rate differential between countries A and B is:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑙 = 𝐸(𝐼𝑁𝐹 ) − 𝐸(𝐼𝑁𝐹 )
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑙 = (𝑖 − 𝑅𝑒𝑎𝑙 ) − (𝑖 − 𝑅𝑒𝑎𝑙 )

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 Where:
E(INFA) and E(INFB) = expected inflation in countries A and B
iA and iB = nominal interest rate in countries A and B
RealA and RealB = real interest rate in countries A and B

If the real rate required is the same among both countries, the expected inflation
differential is reduced to:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑙 = 𝑖 − 𝑖
This formula is very important as it tells us that if the real interest rate require by savers
is similar across countries, then the difference in expected inflation between the two
countries is equal to the difference in nominal interest rates between the two countries.

Example:
Assume the real interest rate in both Canada and the U.S. is 2% and that
Canadian nominal interest is 13% while in the U.S. it is 8%. Compute the
expected inflation differential between the two countries.
As per the Fisher effect, Canadian inflation is 11% [= 13% - 2%], and the U.S. inflation
is 6% [= 8% - 2%].
Thus, the expected inflation differential between Canada and the U.S. is 5% [= 11% -
6%].
This is the same as the difference between nominal interest in both countries of 5% [=
13% - 8%].

Estimating the Expected Exchange Rate Movement

Once we calculate the expected inflation differential, we can use the PPP theory to
determine how it will impact exchange rates.
Example:
Continuing the previous Canada-U.S. example, we know Canadian inflation is 11%
compared to 6% in the U.S. Since inflation is higher in Canada, we should expect the
CAD to depreciate against the USD as per PPP theory, by around 5%.
If the CAD depreciates by around 5%, U.S. savers who wished to benefit from higher
Canadian interest rates would receive 5% less when converting CAD back to USD.
This would offset the potential advantage of 5% higher interest in Canadian savings.
Thus, their expected returns from Canadian savings would be 8% [=13% nominal
Canadian interest - 5% depreciation of the CAD], same as the interest they would have
got from U.S. investments.

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Implications of the International Fisher Effect
If the IFE condition holds, countries with higher interest rates should exhibit high levels
of expected inflation, so that currencies of those countries will depreciate, based on
PPP theory.
The expected depreciation is similar to the expected inflation differential.

Implications of the IFE for Foreign Investors

The implications are similar if foreign investors in countries with relatively low nominal
interest rates attempt to capitalize on high U.S. interest rates (assuming U.S. as the
home country).
Example:
Suppose the nominal interest rate in the U.S. is 8%, and 5% in Japan, while the real
interest rate is 2% in each country.
According to the Fisher effect, the U.S. inflation rate is expected to be 6% [= 8% - 2%]
while inflation in Japan is expected to be 3% [= 5% - 2%]. Therefore, the expected
inflation differential between U.S. and Japan is 3% [= 6% - 3%]. This is again equal to
the difference in nominal rates.
Applying PPP theory to the expected inflation of the two countries, the JPY is expected
to appreciate against the USD by the expected inflation differential of 3%.
If the JPY appreciates by 3%, Japanese savers who tried to benefit from higher
interests in U.S. would receive 3% less when converting USD back to JPY. This offsets
any interest advantage they would have got by investing in U.S. rather than in Japan.
Their ultimate return from investing in the U.S. would be 5% [= 8% U.S. nominal rate
– 3% JPY appreciation or USD depreciation], same as the nominal interest in Japan.

Implications of the IFE for Two Non-U.S. Currencies

The IFE also applies to exchange rates involving the currencies of any two non-U.S.
countries whose exchange rate systems allow exchange rates to float.
Example:
Continuing with Japanese nominal rates at 5% and Canadian nominal rates at 13%,
with real rates in both countries at 2%. This implies an inflation differential between
Canada and Japan of 8%.
Applying the PPP theory here should cause the CAD to depreciate against the JPY.
Therefore, even though Japanese savers would earn extra 8% on Canadian savings,
the depreciation of the CAD by 8% would cause this extra gain to be offset.
Thus, the final gain they get on Canadian investments is 5% [= 13% nominal Canadian
rate – 8% depreciation of the CAD].
All three implications can be illustrated below:

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Derivation of the International Fisher Effect
While in the home country the return on securities is the nominal interest rate, the
return on foreign securities depends on the foreign nominal interest rate (if) and the
percentage change in value of the foreign currency (ef).
Then, the formula for the actual or “effective” return on a foreign security is:

𝑟 = 1+𝑖 1+𝑒 −1

IFE theory states that the effective return on foreign securities should equal to the
interest rate on a local security:
𝐸(𝑟) = 𝑖
Where:
r = effective return on the foreign security
ih = interest rate on the home security
Thus, we can determine by how much the foreign currency should change to make
both home and foreign securities give similar returns. To do this, we equate r to ih:
𝑟=𝑖

1+𝑖 1+𝑒 −1=𝑖

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Now, solving for ef:

1+𝑖 1+𝑒 =1+𝑖

1+𝑖
1+𝑒 =
1+𝑖

1+𝑖
𝑒 = −1
1+𝑖

The IFE theory thus states that:

1) If ih > if, then ef will be positive because the low foreign interest rate reflects low
inflationary expectations in that country.
That is, the foreign currency will appreciate when the foreign interest rate is
lower than the home interest rate.

2) If ih < if, then ef will be negative because the high foreign interest rate reflects
high inflationary expectations in that country.
That is, the foreign currency will depreciate when the foreign interest rate is
higher than the home interest rate.

Example:
Assume the interest rate on a 1-year local bank deposit is 11% and the interest
rate on a 1-year foreign bank deposit is 12%. For the actual return of these two
investments to be similar, from the perspective of local investors, what is the
expected change in the foreign currency?
The foreign currency will have to change over the 1-year period by:
1+𝑖
𝑒 = −1
1+𝑖

1 + 11%
𝑒 = −1
1 + 12%

𝑒 = −0.89%

The below figure summarizes the IFE theory:

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Similar to the PPP theory, the IFE theory is more strongly applicable when the two
countries of concern heavily trade with each other.

Simplified Relationship
A simplified (but less precise) relationship specified by IFE is:
𝑒 ≈𝑖 −𝑖

That is, the percentage change in the exchange rate over the investment horizon will
equal the interest rate differential between the two countries. This approximation is
reliable only when the interest rate differential is small.

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Graphical Analysis of the International Fisher Effect

The figure shows a set of points that conform to IFE theory.

For instance, point E shows a situation where foreign interest rate exceeds the home
interest rate by around 3%; and accordingly, the foreign currency has depreciated by
3% to offset the interest rate advantage.
Thus, an investor gets the same return abroad as they would have received at home.
Point F represents a home interest rate of that is 2% higher than the foreign interest
rate. In this case, local investors who invest abroad receive 2% less from foreign
investments than local investments. But IFE theory holds that foreign currency must
appreciate in such a situation by 2% to offset this interest rate disadvantage.
Point F also illustrates the IFE from a foreign investor’s perspective. For foreign
investors our local rate seems attractive, however, IFE theory holds that foreign
currency will appreciate (or local currency depreciates) by 2%, offsetting the foreign
investor’s interest rate advantage.

Points on the IFE Line

All the points on the IFE line reflect exchange rate adjustments to offset the differential
interest rates.
This means that when we consider the exchange rate movements, investors will end
up achieving the same return whether they invest at home or in a foreign country.

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Points below the IFE Line
Points below the IFE line generally reflects higher returns from investing in foreign
deposits.
Point G indicates that the foreign interest rate is higher than the local interest rate by
3%. The foreign currency has appreciated by 2%.
Then investing in a foreign security will give high returns than possible locally since it
combines higher foreign interest plus high foreign currency value.

Points above the IFE Line

Points above the IFE line generally reflects returns from foreign investments that are
lower than the local returns.
Point H reflects a foreign interest rate 3% higher than local rates. Yet point H also
shows that the exchange rate of the foreign currency has depreciated by 5%, more
than offsetting the interest rate advantage.
At point J the local investor is discouraged from foreign investors due to:
1) The foreign interest rate being lower than the home rate
2) The foreign currency depreciates during the investment period

Testing the International Fisher Effect

If the actual points (one for each period) of interest rates and exchange rates were
plotted over time on a graph as above, we can determine whether the points are
systematically below the IFE line (suggesting higher returns from foreign investments),
above the line (suggesting lower returns from foreign investments) or evenly scattered
on both sides (higher returns in some periods and lower returns in others).

Statistical Test of the IFE

A simple statistical test of the IFE can be developed by applying regression analysis
to historical exchange rates and the nominal interest rate differential.

Limitations of the IFE Theory

We know that the IFE proposes:
1) How each country’s nominal interest rate can be used to derive its expected
inflation rate

2) How the difference in inflation rates between two countries signals expected
change in exchange rates

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Limitations of Deriving the Expected Inflation Rate
If you compare the expected inflation rate of a country (from the nominal interest rate)
in any period to the country’s actual reported inflation rate, there will sometimes be a
discrepancy.
In such a case the difference between the nominal interest rates of two countries may
not properly reflect the level of expected change in exchange rates.

Limitations of PPP
The IFE is limited because it relies on the PPP relationship between inflation and
exchange rates, which is subject to error.
Mainly because there are other country characteristics besides inflation that can affect
exchange rate movements, such as income levels, government controls.
Thus, even if the expected inflation derived from the nominal interest rate (according
to Fisher effect) properly reflects the actual inflation, relying solely on inflation to
forecast the future exchange rate is subject to error.

IFE Theory versus Reality

The IFE theory contradicts the argument about how a country with a high interest rate
can attract more capital inflows and therefore causes the local currency’s value to
strengthen.
The IFE also contradicts the argument about how a central bank may purposely try to
raise interest rates in order to attract funds and strengthen the value of its local
currency.
In reality a currency with a high interest rate strengthens in some situations, which is
contradictory to the IFE theory.
Whether the IFE actually holds depends on the countries involves and also on the
periods that are assessed.
The IFE theory may be especially meaningful in cases where MNCs and investors
consider investing in countries where prevailing interest rates are extremely high.
These countries are usually less developed and have high inflation, and their
currencies tend to weaken substantially over time.

Comparison of IRP, PPP, and IFE Theories

The three theories of interest rate parity, purchasing power parity, and the international
Fisher effect can be summarised as below:

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Even though all three theories relate to determining exchange rate, they have different
implications.
The IRP theory focuses on why the forward rate differs from the spot rate and on how
much the difference should be at a specific point in time.
The PPP theory and IFE theory both focus on the currency’s spot rate will change over
time.
PPP theory suggests that the spot rate will change in accordance with inflation
differential between two countries.
IFE theory suggests that the spot rate will change in accordance with the nominal
interest rate differential (and thus, the inflation differential) between two countries.
The IFE relies on the Fisher effect to determine how the expected inflation differential
can be measured based on prevailing nominal interest rates, and then applies it to
PPP theory to predict exchange rate changes.

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Summary
 Purchasing power parity (PPP) theory specifies a precise relationship between
the relative inflation rates of two countries and their exchange rate. PPP theory
suggests that the equilibrium exchange rate will adjust by about the same
magnitude as the difference between the two countries’ inflation rates. While
there is evidence of significant real-world deviations from the theory, PPP offers
a logical explanation for why currencies of countries with high inflation tend to
weaken over time.

 The international Fisher effect (IFE) theory specifies a precise relationship

between relative nominal interest rates between two countries and their
exchange rates. It suggests that an investor who periodically invests in interest-
bearing foreign securities will, on average, achieve a return similar to what is
possible domestically. This implies that the currency of the country with high
nominal interest rates will depreciate to offset the interest rate advantage
achieved by foreign investments. Yet there is evidence that the IFE does not
hold during all periods, which means that investment in foreign short-term
securities may achieve a higher return than what is possible domestically.
However, a firm that attempts to achieve this higher return also incurs the risk
that the currency denominating the foreign security depreciates against the
investor’s home currency during the investment period by more than the
nominal interest rate differential. In that case, the foreign security would
generate a lower return than a domestic security even though it has a higher
nominal interest rate.

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