INTEREST RATES AND INFLATION To better understand the relationship between interest rates and exchange
INTEREST RATES AND INFLATION To better understand the relationship between interest rates and exchange
rates, we now consider how inflation can be related to both. To link exchange rates, interest rates, and inflation, we must first understand the role of inflation in interest rate determination. Economists distinguish between real and nominal rates of interest. The nominal interest rate is the rate actually observed in the market. The real rate is a concept that mea- sures the return after adjusting for inflation. If you lend someone money and charge that person 5 percent interest on the loan, the real return on your loan is less when there is inflation. For instance, if the rate of infla- tion is 10 percent, then the debtor will pay back the loan with dollars that are worth less. In fact, so much less that you, the lender, end up with less purchasing power than you had when you initially made the loan.
This all means that the nominal rate of interest will tend to incorpo- rate inflation expectations in order to provide lenders with a real return for the use of their money. The expected effect of inflation on the nominal interest rate is often called the Fisher effect (after Irving Fisher, a pioneer of the determinants of interest rates), and the relationship between inflation and interest rates is given by the Fisher equation:
i5r1π e
ð6 :5Þ where i is the nominal interest rate, r the real rate, and π e the expected
rate of inflation. Thus, an increase in π e will tend to increase i. For exam- ple, the fact that interest rates in the 1970s were much higher than in the 1960s is the result of higher inflationary expectations in the 1970s. Across countries, at a specific time, we should expect interest rates to vary with inflation. Table 6.1 shows that nominal interest rates tend to be higher in
120 International Money and Finance
Table 6.1 Interest Rates and Inflation Rates for Selected Countries, 2010 2011 Country
Inflation rate (%), 2010 Interest rate (%), 2011 Japan
20.70 0.03 United States
Note: The inflation rate is equal to the annual rate of change in the consumer price index from the CIA World Factbook. The interest rate is equal to the highest deposit rate quoted for October 2011 by International Deposit of Interest Exchange at http://www.deposits.org/ .
are all linked. First, consider the Fisher equation for the United States and the United Kingdom:
e $ 5r $ 1π $ for the United States ;
and
d 5r d 1π d for the United Kingdom : Global investors will want to have as high as possible real returns from
their investments. If global markets allow free flow of capital, one might expect that the real returns across countries equalize. If we assume that
the real rate of interest is the same internationally, then r $ 5r d . In this case, the nominal interest rates, i $ and i d , differ solely by expected inflation, so we can write
$ 2i d 5π $ 2π d ð6 :6Þ The interest parity condition of Equation (6.3) indicates that the
interest differential is also equal to the forward premium, or i
$ 2i d 5π $ 2π d 5 ðF 2 SÞ=E ð6 :7Þ Equation (6.7) summarizes the link among interest, inflation, and
exchange rates. In the real world, the interrelationships summarized by Equation (6.7) are determined simultaneously, because interest rates, inflation expectations,
Exchange Rates, Interest Rates, and Interest Parity 121
is changed, we would expect F to carry much of the adjustment burden. If the expected future spot rate is unchanged, the current spot rate would tend to carry the bulk of the adjustment burden. Finally, if central bank intervention is pegging exchange rates at fixed levels by buying and selling to maintain the fixed rate, the domestic and foreign currency interest rates will have to adjust to parity levels. The fundamental point is that the initial U.S. policy change led to changes in inflationary expectations, interest rates, and exchange rates simultaneously, since they all adjust to new equilibrium levels.