Page 78 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 5: Currency Forecasting

measures the percentage by which the inflation in the foreign country is higher or lower relative Notes
to the home country. The points in the diagram show that given the inflation differential between
the home and the foreign country, say by X per cent, the foreign currency should adjust by X per
cent due to the differential in inflation rates. The diagonal line connecting all these points
together is known as the PPP line and it depicts the equilibrium position between a change in
the exchange rates and relative inflation rates.
For example, point A represents an equilibrium point where inflation in the foreign country,
say UK, is 4% lower than the home country, say India, so that I – I = 4%. This will lead to an
h f
appreciation of the British pound by 4% per annum with respect to the Indian rupee.
Figure 5.1: Impact of Inflation on Exchange Rate under PPP

Point B in the Figure 5.1 shows a point where the difference in the inflation rates in India and
Mexico is assumed to be 3% so that I – I = – 3%. This will lead to an anticipated depreciation of
h f
the Mexican peso by 3 per cent, as depicted by point B. If the exchange rate responds to inflation
differentials according to the PPP, the points will lie on or close to the PPP line.

5.1.4 Empirical Testing of Purchasing Power Parity Theory

Substantial empirical research has been done to test the validity of PPP theory. The general
conclusions of most of these tests have been that PPP does not accurately predict future exchange
rates and that there are significant deviations from PPP persisting for lengthy periods.

Task Examine the relationship between relative inflation rates and exchange rate
movements over time to test whether PPP exists or is their evidence to suggest that there
are significant deviations over time. The exercise could be performed for different
currencies.

Self Assessment

State whether the following statements are true or false:
1. The PPP theory focuses on the inflation-exchange rate relationships.
2. According to PPP Theory the prices of similar products of two different countries should
be equal when measured in a common currency.

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