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IBUS 302: International Finance Topic 9–Fisher Effects Lawrence Schrenk, Instructor 1 (of 18) Learning Objectives 1. 2. 3. 4. Distinguish real versus nominal values. ▪ Calculate the real exchange rate and discuss its implications for international competition. Describe the evidence for PPP and the reasons there may be deviations from it. Explain the international Fischer effect and the forward expectations parity.▪ 2 (of 18) Real versus Nominal Values Nominal Values Values before an adjustment for inflation The price stated in a contract The actual price you will pay either now or later Real Values Values after an adjustment for inflation ‘Constant’ dollars Incorporates only productivity changes 3 (of 18) The Fisher Effect (FE) Variables Nominal return (i) Real Return (r) Inflation (p) Relationship 1 + i 1 + r 1 + E p NOTE: Do not use the approximation: i ≈ r + p 4 (of 18) If PPP Holds If PPP holds There is inflation (i.e., price levels change) FX rates change cancelling the effects of inflation So the changes have been only nominal Real exchange rate (q) = 1. International competitiveness does not change The amount you can buy in dollar terms has not changed. 5 (of 18) If PPP Does Not Hold If PPP does not hold There is inflation (i.e., price levels change) FX rates may change, but do not completely cancel the effects of inflation So some part of the changes are real Real exchange rate (q) ≠ 1. International competitiveness does change The amount you can buy in dollar terms has changed. 6 (of 18) Real Exchange Rate q is the deviation from PPP q is the real exchange rate 1+ p $ q 1+ e 1+ p x e is the (empirical) percentage change in F based on current data. (Do not confuse it with ePPP which is the (theoretical) percentage change in F consistent with relative PPP.) 7 (of 18) ePPP versus e F S e S Formula: Notation (not in the textbook) ePPP is the percentage change in F predicted by PPP. e is the (empirical) percentage change in F based on current data. If e = ePPP, then PPP holds, i.e., no deviation and q = 1 International competitiveness does not change. 8 (of 18) Real Exchange Rate and Competitiveness q and competitiveness < 1 domestic more competitive = 1 no change > 1 domestic less competitive 9 (of 18) Real Exchange Rate Example p$ = 5% p€ = 4% S($/€) = 1.4300 F($/€) = 1.4500 What is q? 10 (of 18) Solution Actual Change in Forward Rate F S 1.4500 1.4300 e S 1.4300 0.0140 1.40% Real Exchange Rate 1+ p $ 1.05 q 1.0212 1+ e 1+ p x 1.01401.014 11 (of 18) Analysis If PPP held, then the forward rate should be: ePPP FPPP p $ p x 0.05 0.04 0.0096 1.04 1+ p x 1.4300 1.0096 1.4438 The actual forward rate, F, is 1.4500, so PPP does not hold, and q > 1, so domestic trade is less competitive 12 (of 18) Practice: Absolute PPP Data US Big Mac $3.54 UK Big Mac £2.29 S($/£) = 1.4689 Questions What is SPPP($/£)? Does absolute PPP hold? 13 (of 18) Practice: Relative PPP S($/£) = 1.4689, F12($/£) = 1.4722, p$ = 7.4%, p£ = 6.1% Question: Does relative PPP hold? What is ePPP? ePPP p $ p x 1+ p x What is FPPP? FPPP ($/x) S($/x) 1 + e 14 (of 18) Practice: Relative PPP S($/£) = 1.4689, F12($/£) = 1.4722, p$ = 7.4%, p£ = 6.1% Question: If not what is the real exchange rate? What is e ? (Remember this is different from ePPP) F S e S What is q? 1+ p $ q 1+ e 1+ p x 15 (of 18) Practice: Relative PPP S($/£) = 1.4689, F12($/£) = 1.4722, p$ = 7.4%, p£ = 6.1% Question: What are the implications for international competition? 16 (of 18) Evidence: Absolute PPP 17 (of 18) Evidence: Relative PPP 18 (of 18) PPP Deviations Transportation Costs Trade Restrictions Shipping costs can remove arbitrage opportunity; imports become relatively more expensive. Example: Pharmaceutical Industry Cost of Non-Tradable Inputs Taxes Productivity 19 (of 18) ‘Big Mac’ Index Index Analysis 20 (of 18) International Fischer Effect and the Forward Expectations Parity 21 (of 18) Overview Interest Rate Parity interest rates (i) → Purchasing Power Parity inflation (p) forward rate → forward rate ↔ inflation (p) Fisher Effect interest rates (i) 22 (of 18) Implications IRP connects FX and interest rates PPP connects FX and inflation Fisher Effect connects interest rates and inflation FX Inflation Interest Rates Fisher Effect 23 (of 18) Fisher Effect (FE) Inflation increases causes interest rate increase. Recall time value of money (TVM) motivations Opportunity Costs Inflation Risk Interest rates must compensate the investor for expected inflation: i 1 + r 1 + E p 1 24 (of 18) Fisher Effect Fisher Effect applies to all currencies individually: i $ 1 + r$ 1 + E p $ 1 i £ 1 + r £ 1 + E p £ 1 25 (of 18) International Fisher Effect (IFE) Combine PPP and FE to get IFE The real rate should be equal r$ = r£ i x rx Rewrite FE as: E p x 1+ rx p $ p x Recall PPP: E ePPP 1 + p x i$ i x IFE 1 + i x Substitute FE into PPP: E e 26 (of 18) Forward Expectations Parity (FEP) Combine IFE and IRP to get FEP i$ i x Recall IFE: E eIFE 1+ i x FIRP S i$ i x Recall IRP (in a different form): S 1+ ix Combine IFE and IRP for FEP: i$ i x FIRP S E eIFE S 1+ i x 27 (of 18) Forward Expectations Parity (FEP): Implications I Percentage Change Analysis i$ i x FFEP S E eIFE S 1+ i x The percentage change in the exchange rate, i.e., the forward premium or discount, is equal to the expected change in the exchange rate. 28 (of 18) Forward Expectations Parity (FEP): Implications II Forward Rate Analysis E FFEP S 1 + E eIFE i$ i x where E eIFE 1+ ix The expected forward rate is equal to the spot rate increased by the expected change in the exchange rate. 29 (of 18) FEP Example S($/A$) = 0.6495, i$ = 4.2%, iA$ = 3.3% i $ i A$ E FFEP S 1 + 1 + i A$ 0.042 0.033 0.6495 1 + 0.6552 1.033 30 (of 18) Implications IRP connects FX and interest rates PPP connects FX and inflation Fisher Effect connects interest rates and inflation ▪ FX FEP ▪ Inflation Interest Rates Fisher Effect 31 (of 18) Fisher Required Formulae Fisher Effect (FE) i 1 + r 1 + E p 1 International Fisher Effect (IFE) i$ i x E eIFE 1 + i x Forward Expectations Parity (FEP) i$ i x FFEP S E eIFE S 1+ i x 32 (of 18)