3. ◦ Direct quote
◦ Price of the foreign currency in terms of
home currency
◦ Indirect quote
◦ Price of the home country in terms of the
foreign currency

4. Foreign Exchange
rate
 P.p.p
 Deviation of P.P.P
 I.F.E
 Derivation of I.F.E
 Compression of
I.R.P,
 p.p.p, I.F.E


5.  theory
attempts to quantify this
inflation – exchange rate relationship.
 When a country’s inflation rate
increase relative to another country,
decreased exports and increased
imports depress the high-inflation
country’s currency.

6. Assume that PPP holds.
Over time, inflation occurs and the exchange rate adjusts to maintain
PPP:
Ph = home country’s price index
Ih = home country’s inflation rate
Pf  Pf (1 + If ) (1 + ef )
where Pf = foreign country’s price index
If = foreign country’s inflation rate
ef = foreign currency’s % D in value
where

7. PPP holds
Ph = Pf and
Ph (1 + Ih ) = Pf (1 + If ) (1 + ef )
Solving for ef :
ef = (1 + Ih ) – 1
(1 + If )

8. PPP does not occur consistently due to:

Exchange rates are also affected by differences
in inflation, interest rates, income levels,
government controls and expectations of future
rates.

for some traded goods

10.  Absolute
form of PPP:
“
”:
price of similar products to two
countries should be equal
when measured in a common
currency.

11.  Acknowledges
market imperfections
such as:
 Rate
of change in the prices of
products should be similar when
measured in a common currency.

12.  I.F.E
describe that inflation and both real
and nominal interest rate. The fisher
effect state that the real interest rate equal
the nominal interest rate minus expected
inflation. therefore real interest rate fall
as inflation increase unless nominal
interest rate increase at the same rate

13. 
Setting rf = rh : (1 + if )(1 + ef ) – 1 = ih

When the interest rate differential is small, the
IFE relationship can be simplified as
ef
ih
_
if

14. (PPP)

15. Forward rate premium
Interest rate differential
p
ih – if
p
% in spot exchange rate ef
Inflation rate differential Ih – If
% in spot exchange rate ef
Interest rate differential ih – if
ef
ef
1 ih
1 if
1 Ih
1 If
1 ih
1 if
1 ih i f
1
Ih
If
1 ih
if