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- This topic has 5 replies, 2 voices, and was last updated 1 year ago by John Moffat.

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- March 29, 2021 at 8:11 pm #615474
Can you please explain the effect of change in inflation & interest rates in one country

over another country with an example using Purchase Power Parity & Interest Power Parity Formulas?“If we consider Pounds as Local Currency & Dollars as Foreign Currency”

In case of the Pounds inflation or interest rate increases, it will result in fewer Dollars thus, indicating appreciation of Dollars. Therefore, indicating the Dollar appreciates because now there will be fewer Dollars for 1 POUND. [Correct?]

In case of the Pounds inflation or interest rate decreases, it will result in more Dollars thus, indicating depreciation of Dollars. Therefore, indicating the Dollar depreciates because now there will be more Dollars for 1 POUND. [Correct?]

March 30, 2021 at 8:31 am #615492PPP is used to forecast future spot rates, and this is all explained (with examples) in my free lectures on forecasting spot rates.

IRP is used to determine forward rates, and is explained in my lectures on foreign exchange risk management.

March 30, 2021 at 5:01 pm #615532Sir, Your answer is quite ambiguous for what I really asked. I have already watched your lecture on ‘Forecasting Foreign Currency Exchange rate’ with examples in the notes that u explained very well. I do appreciate your explanation there. 🙂

BUT I wanted to get to know the cause & effect of Inflation and Interest rate when they increase & decrease on counter-currency.

All I know is that an Increase in INFLATION rate & Interest rate of Local Currency will cause a reduction in exchange rate of Foreign Currency because NOW there will be LESS Foreign Currency that can be BOUGHT.

I have tried to prove this by using Purchase Power Parity & Interest Rate Parity Formula:

PURCHASE POWER PARITY

When there is an increase in inflation rate of Local Currency £

S1 = So x (1 + Foreign Inflation rate / Local Inflation rate)

S1 = $1.543 x (1 + 3% / 1 + 5%)

S1 = $1.513 [Dollar appreciates]

Dollar appreciates because now there will be fewer Dollars for £1INTEREST RATE PARITY

When there is an increase in interest rate of Local Currency £

S1 = So x (1 + Foreign Inflation rate / Local Inflation rate)

S1 = $1.543 x (1 + 3% / 1 + 5%)

S1 = $1.513 [Dollar appreciates]

Dollar appreciates because now there will be fewer Dollars for £1However, If there is a decrease in the rate of inflation & interest this will cause an increase in exchange rate of Foreign Currency because NOW there will be more Foreign Currency that can be bought.

I have tried to prove this by using Purchase Power Parity & Interest Rate Parity Formula:

PURCHASE POWER PARITY

When there is a decrease in inflation rate of Local Currency £

S1 = So x (1 + Foreign Inflation rate / Local Inflation rate)

S1 = $1.543 x (1 + 3% / 1 + 5%)

S1 = $1.513 [Dollar depreciates]

Dollar depreciates because now there will be more Dollars for £1INTEREST RATE PARITY

When there is a decrease in interest rate of Local Currency £

S1 = So x (1 + Foreign Inflation rate / Local Inflation rate)

S1 = $1.543 x (1 + 3% / 1 + 5%)

S1 = $1.513 [Dollar depreciates]

Dollar depreciates because now there will be more Dollars for £1March 31, 2021 at 8:14 am #615567I am puzzled because all the workings that you have typed out are exactly the same, and in all them them the dollar has appreciated because one pound buys fewer dollars.

The two statements in your original post are correct and result from the application of the formula – there is nothing to prove.

Appreciate that PPP is only used to forecast future exchange rates in the exam but in practice there are lots of other factors that influence the exchange rate.

IRP (as I wrote before) is not forecasting anything – it is purely based on interest rates and using money market heading to fixed the forward rate.In a perfect world the future spot rate would equal the forward rate (because in a perfect world inflation rates and interest rates move up and down together). However this is not the case in the ‘real’ world – partly because interest rates and inflation rates do not move together (in the short term) and because other factors influence the spot rate.

April 1, 2021 at 5:15 pm #615692Apologies Sir, I have mistyped the answer in last response of mine.

There is a question in September-December 2016 past paper Q19) Herd Co

Which of the following statements support the finance director’s belief that euro

[which is Foreign currency] will depreciate against the dollar [which is Local currency]?1) The dollar inflation rate is greater than the euro inflation rate

2) The dollar interest rate is less than the euro interest rateI am troubled by this question where I was trying to figure out the answer by using PPP & IRP formula whether what is going to happen if there is a change in inflation & interest rates on other currency. Pls help me with this!

April 2, 2021 at 8:51 am #615737If the dollar inflation is more than the euro inflation, then using the PPP formula, the €/$ exchange rate will be lower than 1.543. Given that this means that a dollar will buy fewer euros, the euro will have apppreciated.

If the dollar interest is lower then the euro interest rate, then using the same formula (because in theory interest rates and inflation rates go up and down together) the exchange rate will be higher than 1.543. So a $ will buy more euros and so the euro will have depreciated.

Although the examiners answer is correct as B (only statement 2 in the question means that the euro will depreciate), the wording of the second sentence of the answer is mistyped. It should read

“If the dollar inflation rate is more than the euro inflation rate……”. - AuthorPosts

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