The Relationship among International Parity Conditions

In the short run, most international parity conditions do not hold. However, over longer periods, they enjoy significant interaction among themselves courtesy of the interrelationship between interest rates, inflation rates, and exchange rates. Most notably:

1. According to the ex-ante version of PPP, the expected change in spot exchange rates should equal the difference between the inflation rates of foreign and domestic countries.
2. Provided that the ex-ante PPP and the Fisher effect hold, the difference in the foreign and domestic inflation rates must be equal to both the expected change in the exchange rate and the nominal interest rate differential. This is called the uncovered interest rate parity.
3. When the Fisher effect holds, the difference between the foreign and domestic interest rates will be equal to the domestic-foreign expected inflation rate differential, which essentially is the international Fisher’s effect.
4. Assuming that both covered and uncovered interest parities hold, the forward exchange rate will be an unbiased predictor of the future spot exchange rate.
5. In the uncovered interest parity, the expected percentage change of the spot exchange rate is expected to be reflected in the nominal interest rate spread.
6. In the covered interest rate parity, arbitrage evens off the nominal interest rate spread and the percentage forward premium or discount.

Looking at the points above, if all the international conditions are held constant most of the time, the spot exchange rate must be equal to the following:

1. The difference (spread) in nominal interest rate (yield) between two countries.
2. The percentage forward premium or discount.
3. The expected national inflation rate differential.

Question

The International Fisher effect is least likely based on which of the following?

1. Real interest rate parity.
2. Ex-ante PPP.
3. Absolute PPP.

Solution

The correct answer is C.

The International Fisher’s effect assumes that both real interest rate and ex-ante PPP hold.

Reading 8: Currency Exchange Rates: Understanding Equilibrium Value

LOS 8 (f) Describe the relations among the international parity conditions.