Page 85 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes US dollar (the second column) for each country. From the table, we see that, except for
France and Canada for the 1988–2001 period, all the nations that faced lower inflation rates
Gap (Japan and Germany) than the United States experienced an appreciation of their
currencies, while those that had a higher inflation rate experienced a depreciation of their
currencies. Since the actual values in the first and second column in each of the three time
periods in table often exhibit large differences, we cannot say that the relative PPP theory
works very well in predicting even long-term exchange rates.
Table 1: Differences in Relative Inflation Rates and
Currency Depreciation, 1973-2001

Country 1973-1987 1988-2001 1973-2001
Inflation Currency Inflation Currency Inflation Currency
Difference Depreciation Difference Depreciation Difference Depreciation
Japan -15.8 -61.1 -20.3 -5.3 -32.5 -120.3
Germany -27.2 -39.2 -2.9 21.8 -29.6 -25.7
France 32.6 29.8 -10.0 20.7 20.9 43.3
United 47.1 39.8 14.1 21.2 46.0 45.6
Kingdom
Italy 70.7 76.4 21.9 49.8 64.6 91.2
Canada 12.4 28.0 -2.4 22.9 9.7 39.5

Questions
1. What do you mean by currency depreciation?
2. Discuss relative purchasing power parity?
Source: International Business Environment, Raj Kumar.

5.5 Summary

At the cornerstone of international finance relations, there are three international interest
parity conditions, viz., the covered interest parity, the PPP doctrine and the international
fisher effect.
These parity conditions indicate degree of market integration of the domestic economy
with the rest of the world.
The PPP theory focuses on the inflation-exchange rate relationship. Substantial empirical
research has been done to test the validity of PPP theory.

The general consensus has been that PPP does not accurately predict future exchange rates
and there are significant deviations from PPP persisting for lengthy periods.

The IFE uses interest rates rather than inflation rate differential to explain the changes in
exchange rates over time.
IFE is closely related to PPP because interest rates are significantly correlated with inflation
rates.

5.6 Keywords

Absolute PPP Theory: Absolute PPP theory postulates that the equilibrium exchange rate between
currencies of two countries is equal to the ratio of the price levels in the two nations.

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