What are the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates?
To produce order out of chaos, the international financial manager needs some model of the relationships between exchange rates, interest rates, and inflation rates. Four very simple theories prove useful: • In its strict form, purchasing power parity states that $1 must have the same purchasing power in every country. You only need to take a vacation abroad to know that this doesn’t square well with the facts. Nevertheless, on average, changes in exchange rates tend to match differences in inflation rates and, if you need a long-term forecast of the exchange rate, it is difficult to do much better than to assume that the exchange rate will offset the effect of any differences in the inflation rates. • In an open world capital market real rates of interest would have to be the same. Thus differences in nominal interest rates result from differences in expected inflation rates. This international Fisher effect suggests that firms should not simply borrow where interest rates are lowest.
Related Questions
- What are the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates?
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