In the context of PPP, if the expected inflation rate differential between the U.S. and Japan increases, what should market participants expect the dollar to do over time (appreciate or depreciate)? Explain.
by relative PPP S in /Y \* (1+I())/(1+I(Y)) = F (/Y) since 1+I/1+IY is > 1 F (/Y) \> S (S/Y) this means that depreciates.
You’re right on that. The confusion I got (sorry about that) was actually on the interest rate parity, which says the same thing as above, i.e.: In the context of interest rate parity, if the nominal interest rate differential between the U.S. and Japan increases (risk-free rate in the U.S. higher than in Japan), what should market participants expect the dollar to do over time (appreciate or depreciate)? The answer is the same, dollar depreciates, but here is the issue: Somewhere else it says that if interest rates are higher in the U.S., that this leads to the dollar appreciating because foreigners start buying financial assets (to take advantage of teh higher rates) and deposit money in the U.S. (which raises the Fianncial Account in the balance of payment). If that’s the case, then the dollar should appreciate not deprectiate.
Isn’t the 2nd one stated in terms of “real interest rates”? Which means inflation adjusted?
hey Dreary, I am having the same confusion, too. I am confused on the impact of the economic growth on the currency… will the cc be appreciating because of higher economic growth or not? Thanks! M.
I’ll try explain in general term. PPP says a Big Mac in New York should be the same price as in Tokyo, say 1 USD = 1 Big Mac = 100yen, i.e. 1 USD = 100 yen If inflation in Tokyo is higher than New York, 1 Big Mac needs 150 yen. According to PPP, 1 USD = 1 Big Mac = 150 yen. Thus yen depreciates and USD appreciates.
Yes, the assumption here is that if interest rates are higher, inflation is higher. The only issue I have is how to reconcile the fact that when interest rates are higher which leads to higher demand for dollar, with the conclusion that the dollar will depreciate over time. Back to PPP, here is an example that shows that the dollar does indeed depreciate: Gold is priced at 700/ounce in the U.S. Gold is priced at Y70,000/ounce in the Japan. So, the exchange rate is Y100/ (Y70,000/$700). Assume U.S. inflation is 5% and Japan’s inflation is 1%. Then the price of gold a year from now will be 5% higher in the U.S. (735), and 1% higher in Japan (Y70,700), so the exchange rate will be Y96.19/ (Y70,700/$735), which shows that the dollar depreciates.
> I am having the same confusion, too. I am confused on the impact of the economic growth > on the currency… will the cc be appreciating because of higher economic growth or not? It depends on whether it is growth with or without inflation. If the economy is operating at full employment, and money supply is increased, then inflation occurs, which leads eventually to the local curency depreciating. But if the economy is below full employment, then easing the monetary policy or increasing government spending (fiscal policy) does not lead to inflation, so the local currency is not affected by this action per se. However, due to the economic growth, more exports lead to appreciating local currency. So, I would say that local currency deprectiates if at full employment, and appreciates if below full employment.