BUSF_A01.qxd

Foreign exchange

Purchasing power parity(PPP) can be summarised as follows:

= (15.1)

where e 0 is the value in terms of the home country currency of one unit of the foreign

currency at the start of a period, e 1 is the value in terms of the home country currency

of one unit of the foreign currency at the end of the period, ihis the rate of inflation

in the home country during the period and ifis the rate of inflation in the foreign

country during the period.

To illustrate how this works, continue to assume a current exchange rate of

£1 =US$1.95. Let us also assume that the inflation rate during the next year will be

10 per cent in the UK and 5 per cent in the USA. At present, according to the law of

one price, a product that costs £1 in the UK will cost $1.95 in the USA.

At the end of the year, the product will cost £1 (1 +10%) =£1.10 in the UK and

$1.95 (1 +5%) =$2.05 in the USA. This should mean that, by the end of the year,

£1 will be worth 2.05/1.10 =$1.86.

Going back to equation (15.1), and bearing in mind that at the start of the period

$1 =£0.51 (that is, 1/1.95):

e 1 =

==0.53

• that is:

$1 =£0.53 or £1 =$1.86

Since the law of one price does not work strictly in practice, it is not surprising to find

that PPP does not strictly operate in practice either. However, as Shapiro and Balbirer

(2000) showed, those countries with the highest levels of inflation during the 1980s

showed the highest rates of currency value depreciation, or decline, as PPP would predict.

Fisher effect

The law of one price would lead us to the conclusion that the real (ignoring inflation)

interest rate should be the same in any country, assuming deposits with a similar level

of risk. If this were not the case, funds would flow across borders seeking the best returns

to such an extent that interest rates would alter and/or exchange rates would change

making real interest rates equal. This phenomenon is known as the Fisher effect.

As we saw in Chapter 5, in the context of investment appraisal:

1 +rn=(1 +rr)(1 +i)

where rnis the nominal (or money) interest rate (that is, the rate that we actually have

to pay to borrow, which takes account of inflation), rris the real interest rate and iis

the rate of inflation. Then:

1 +rr=^1 +rn

1 +i

(1 +0.10) ×0.51

1 +0.05

(1 +ih)e 0

1 +if

1 +ih

1 +if

e 1

e 0

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