Madura chapter 8 notes

p. 255
What is the implication of the 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.
p. 256
What does the relative form of PPP account for that the
absolute version does not?
The relative form of PPP accounts for such market
imperfections as transportation costs, tariffs, and
quotas. This version acknowledges that these
imperfections make it unlikely for prices of the
same basket of goods in different countries to be
the same when measured in a common currency.
What does the relative form of PPP suggest about the
prices of the same basket of goods in different countries?
The relative form of PPP suggests that the rate of
change in the prices of those baskets should be
comparable when measured in a common currency
(assuming that transportation costs and trade
barriers are unchanged).
p. 257
Suppose that the home currency experiences an inflation
rate of 5% while the foreign country experiences a 9.5%
inflation rate. According to PPP, how will the foreign
currency adjust?
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Madura chapter 8 notes

The foreign currency will adjust by (1 + 0.05)/(1 +
0.095) - 1 = -0.0411
This is roughly equal to the approximation 0.05 0.095 = -0.045
Skip the PPP line material.
p. 262-3
Write down the model given in the text for a simplified
statistical test of PPP.
%Change in the exchange rate
= a0 + a1 * ((1 + iUSD)/(1 + iFX) - 1) + mu
where mu is an error term.
What are the hypothesized values of a0 and a1? Why?
a0 should = 0, because based on parity
relationships, the only thing that should be driving
the exchange rate is differences in the (nominal)
interest rate (or equivalently, if the real rates are
equal, the difference in the inflation rates).
a1 should = 1, because the interest rate (or
inflation rate) differential should exactly offset the
movement in the exchange rate.
Describe in words what is being tested in this model.
#1. Is there something other than the interest rate
(or inflation rate) differential that is driving
movements in exchange rates?
#2. Does the interest rate (or inflation rate)
differential, on average, completely offset the
movement in the exchange rate?
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Madura chapter 8 notes

p. 265
When we apply the Fisher Effect to derive expected
inflation per country, the first step is to derive
__________________.
the expected inflation rates of the two countries
based on the Fisher effect's claim that the nominal
interest rate in the two countries differs only
because of the difference in their expected
inflation rates.

In order to use the IFE to predict inflation, what must we

assume about the real interest rate in each country?
We must assume that the real interest rates are
equal.
In order to use the IFE to predict inflation, what must we
assume about the difference between the nominal
interest rates in each country?
The difference between the nominal interest rates
is driven by the difference in inflation rates.
p. 265-6
The second step when using the international Fisher
effect to predict movements in the exchange rate is
______________________
to determine via PPP how the exchange rate would
change in response to the two countries' expected
inflation rates, as calculated in the first step.
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Madura chapter 8 notes

p. 266
The discussion (in the book) so far indicates that
currencies with high interest rates will exhibit __________
expected inflation (because of the ___________) and that
this relatively __________ inflation will cause those
currencies to _________________ (because of ____________).
high; IFE; high; depreciate; PPP
This explains why MNCs and investors based in the
_________________ may refrain from investments in the
interest-bearing securities of these countries; the
______________ effect could offset the ____________________
advantage.
United States; exchange rate; interest rate
**Connecting the current chapter with previous
material:
**What theory have we studied that predicts that these
two effects should offset each other?
Interest rate parity and the zero arbitrage
condition for uncovered interest parity.
**Do these effects typically offset each other? If they
don't, give an example where these effects do not offset
each other on average.
No, these effects do not, on average, completely
offset each other.
One example is carry trades. On average, it is
possible to earn a profit by borrowing in a
relatively low interest rate country, such as Japan,
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and lending in a relatively higher interest rate
country, such as the US. This would not happen if
the interest rate differential offset the entire
movement in the exchange rate.
**Basic math/econ/etc application
In the text on p. 265, the authors give the following
example:
Example: If the US nominal interest rate is 5% and if the
real interest rate is 2%, then the expected inflation rate
is 3%.
Calculate the expected inflation rate without using the
approximation the authors used.
= (1 + 0.05)/(1 + 0.02) - 1 = 1.05/1.02 - 1 = 0.0294
= 2.94%

p. 274
The IRP theory focuses on why the ________________ differs
from the ____________ and on how much the
________________ should be at a specific point in time.
forward rate; spot rate; difference
In contrast, the ______________ and the ______________ both
focus on how a currency's spot rate will change over time.
PPE; IFE
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Madura chapter 8 notes

Whereas PPP theory suggests that the spot rate will
change in accordance with ______________, IFE theory
suggests that the spot rate will change in accordance
with ____________________________.
inflation differentials; interest rate differentials