Inflation, Interest Rate, and Exchange Rate: What is the Relationship

Inflation, Interest Rate, and Exchange Rate: What is the Relationship? by Maurice K. Shalishali and Johnny C. Ho

I. Enumerate the following as stated in the article:

1. The importance of the information gained in applying the International Fisher Effect theory.

Answer: The importance of the International Fisher Effect Theory is that, it is useful in international business, export opportunities and price competitiveness of foreign imports. It is also important because it links interest rates, inflation and exchange rates.

2. The eight selected industrialized countries that were selected for the International Fisher Effect theory.

Answer: The eight countries that were selected for the International Fisher Effect Theory are- Canada, France, Germany, Japan, Netherlands, Sweden, Switzerland, United Kingdom

II. Based on the results of the study, identify whether the following statements are TRUE or FALSE.

1. The International Fisher Effect theory and Purchasing Power Parity are inversely related because of high correlation between interest rates and inflation rates.

Answer: FALSE

2. Data included monthly money market interest rates and percentage change in the exchange rate.

Answer: FALSE

3. The equation states that the actual or effective rate on a foreign money market security depends on foreign interest rate as well as the percent change in the value of foreign currency denominating the security.

Answer: TRUE

4. Assuming that the real rate of return is the same across countries, the difference in the expected inflation interest rate between countries is due to the differences in nominal interest rates.

Answer: FALSE

5. The International Fisher Effect theory holds for all countries.

Answer: FALSE

III. Given , derive the formula for for the effective return on a foreign bank deposit r.

Answer:in = r

in = (1 + ir) (1 + er) 1

in + 1 = (1 + ir) (1 + er)

(1 + ir) (1 + ir)

1 + er = in + 1

(1 + ir)

er = in + 1 - 1

(1 + ir)

IV. Answer the following questions completely.

1. List down the pairing (home country vs. foreign country) wherein the test did not hold.

Answer: Canada=Japan

France=Canada, United Kingdom

Germany=Canada, Japan, United Kingdom

Japan=Canada, United Kingdom

Netherland=Canada, Switzerland

Sweden=Canada, Switzerland, United Kingdom

Switzerland=Canada, United Kingdom

United Kingdom=Sweden, Switzerland

2. List down the pairing (foreign country vs. home country) wherein the test did not hold.

Answer:Canada=France, Germany, Japan, Netherland, Sweden,

Switzerland

France=none

Germany=none

Japan=Canada, Germany

Netherland=none

Sweden=United Kingdom

Switzerland=Netherland, Sweden, United Kingdom

United Kingdom=France, Germany, Japan, Sweden, Switzerland

3. What are the suggestions for the mixed outcomes?

Answer: If the theory holds for some countries, it does not hold for others. The results are mixed. It suggests that there may be some impediments to foreign trade that may affect exchange rate adjustment apart from interest and inflation rate differentials.