International Interest Rate Differences and the Real Exchange Rate

International Interest Rate Differences
and the Real Exchange Rate
Earlier in this chapter we saw that relative PPP, when combined with interest parity,
implies that international interest rate differences equal differences in countries’
expected inflation rates. Because relative PPP does not hold true in general, however, the
relation between international interest rate differences and national inflation rates is
likely to be more complex in practice than that simple formula suggests. Despite this
complexity, economic policy makers who hope to influence exchange rates, as well as
private individuals who wish to forecast them, cannot succeed without understanding
the factors that cause countries’ interest rates to differ.
E$/€
PUS
q$/€
q$/€
E$/€
q$/€
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 411
In this section we therefore extend our earlier discussion of the Fisher effect to include
real exchange rate movements. We do this by showing that in general, interest rate differences
between countries depend not only on differences in expected inflation, as the
monetary approach asserts, but also on expected changes in the real exchange rate.
We begin by recalling that the change in , the real dollar/euro exchange rate, is the
deviation from relative PPP; that is, the change in is the percentage change in the
nominal dollar/euro exchange rate less the international difference in inflation rates
between the United States and Europe. We thus arrive at the corresponding relationship
between the expected change in the real exchange rate, the expected change in the nominal
rate, and expected inflation:
(16-8)
where (as per our usual notation) is the real exchange rate expected for a year from
today.
Now we return to the interest parity condition between dollar and euro deposits,
An easy rearrangement of (16-8) shows that the expected rate of change in the nominal
dollar/euro exchange rate is just the expected rate of change in the real dollar/euro
exchange rate plus the U.S.–Europe expected inflation difference. Combining (16-8) with
the above interest parity condition, we thus are led to the following breakdown of the
international interest rate gap:
(16-9)
Notice that when the market expects relative PPP to prevail, and the first
term on the right side of this equation drops out. In this special case, (16-9) reduces to the
simpler (16-5), which we derived by assuming relative PPP.
q$/€
e = q$/€
R$ - R€ = [(q$/€
e - q$/€)/q$/€] + (pUS
e - pE e ).
R$ - R€ = (E$/€
e - E$/€)/E$/€.
q$/€
e
(qe
$/€ - q$/€)/q$/€ = [(E$/€
e - E$/€)/E$/€] - (pUS
e - pE e ),
q$/€
q$/€
TABLE 16-1 Effects of Money Market and Output Market Changes
on the Long-Run Nominal Dollar/Euro Exchange Rate, E$/€
Change
Effect on the Long-Run Nominal
Dollar/Euro Exchange Rate, E$/€
Money market
1. Increase in U.S. money supply level Proportional increase (nominal
depreciation of $)
2. Increase in European money supply level Proportional decrease (nominal
depreciation of euro)
3. Increase in U.S. money supply growth rate Increase (nominal depreciation of $)
4. Increase in European money supply growth rate Decrease (nominal depreciation of
euro)
Output market
1. Increase in demand for U.S. output Decrease (nominal appreciation of $)
2. Increase in demand for European output Increase (nominal appreciation
of euro)
3. Output supply increase in the
United States
Ambiguous
4. Output supply increase in Europe Ambiguous
412 PART THREE Exchange Rates and Open-Economy Macroeconomics
In general, however, the dollar/euro interest difference is the sum of two components:
(1) the expected rate of real dollar depreciation against the euro and (2) the
expected inflation difference between the United States and Europe. For example, if
U.S. inflation will be 5 percent per year forever and European inflation will be zero
forever, the long-run interest difference between dollar and euro deposits need not be
the 5 percent that PPP (when combined with interest parity) would suggest. If, in addition,
everyone knows that output demand and supply trends will make the dollar
decline against the euro in real terms at a rate of 1 percent per year, the international
interest spread will actually be 6 percent.