International Parity Conditions

"Prices, Interest Rates, and Exchange Rates in Equilibrium" (International Parity Conditions)

Table of Content

Executive Summary...............................................................3

1. Introduction...................................................................4

2. Literature Review............................................................6

3. Findings and Analysis: ......................................................10

a. PPP....................................................................10

b. FE......................................................................12

c. IFE.....................................................................14

4. Conclusion & Recommendations ..........................................16

Bibliography.........................................................................17

Appendix A. Historical Data......................................................18

Table of Figures

Figure 1. International Parity Conditions

Figure 2. Scatter Diagram for PPP

Figure 3. Time-series data for inflation rates differential and exchange rate change

Figure 4. Regression Plot for PPP

Figure 5. Scatter Diagram for FE

Figure 6. Time-series data for inflation and interest rates differentials

Figure 7. Regression Plot for FE

Figure 8. Scatter Diagram for IFE

Figure 9. Time-series data for interest rates differentials and exchange rate change

Figure 10. Regression Plot for IFE

Executive Summary

This assignment is aimed at examining the evidence for three of the relationships that underpin (explicitly or implicitly) much of international macroeconomics. The first is purchasing power parity (PPP), or the hypothesis that there exists a constant long-run equilibrium real exchange rate. The second is Fisher Effect, which tests the relationship between difference in inflation rates and difference in nominal interest rates. The third establishes a relationship between real exchange rates and real interest rate differentials or International Fisher Effect. The tests are conducted on a basis of two economies: United States and Kazakhstan. The results are obtained using graphs and regression models, which significantly increase the power of the tests. The empirical evidence is evaluated on the basis of historical data for the period of 1999-2003.

The paper is divided into two main parts. The first part contains analysis of the historical data about interest rates, exchange rates, and 3-month T-bills (Kazakhstani name: MEKKAM) in two countries: Kazakhstan and USA. The second part gives implications based on the results of analysis.

Introduction

The core of international finance theory lies in international parity conditions. They bring together prices, interest rates, and exchange rates. As expected rate of change in the spot exchange rate, differential rates of national inflation and interest, forward discount or premium are all interrelated, a change in one of them leads to a change in all the rest, so that the first variable changes again.

In our work we test whether International Parity Conditions hold in the context of the Kazakhstani economy.

In our research we intend to examine the theory of Purchasing power parity, Fisher effect, International Fisher effect, Interest rate parity, and Forward rate as an unbiased predictor of the future spot rate.

Scope of the study

For the purposes of this study we obtain time series data on the American and Kazakhstani interest rates, inflation rates, and exchange rate statistics on quarterly basis for five years (1999-2003).

Limitations

In this paper we consider parity conditions between US and Kazakhstan. Kazakhstani Stock Exchange doesn't trade forward contracts; therefore we are not able to test such conditions as forward rate as unbiased predictor of the future spot rate and interest rate parity. Furthermore, some months T-bills were not issued, that's why we will omit these months in our analysis.

Significance of the study

The study represents an empirical evidence of international parity conditions. It helps explain the long run trend in an exchange rate. This study will help to understand how multinational business is conducted and financed.

Literature review

Alan Shapiro in "Multinational Financial Management" affirms that there are five parity conditions resulted from arbitrage activities based on law of one price: Purchasing Power Parity (PPP); The Fisher Effect (FE); The International Fisher Effect (IFE); Interest Rate Parity (IRP); Unbiased Forward Rate (UFR).

Michael H. Moffet, et al in "Fundamentals of Multinational Finance" say that the PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between countries over a period of time determines the change in exchange rates. Moreover, if the spot rate between 2 countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot rate.

As for empirical tests, they say that both relative and absolute purchasing power parity show that for the most part, PPP tends to not be accurate in predicting future exchange rates. Two general conclusions can be drawn from the tests:

* PPP holds up well over the very long term but is poor for short term estimates

* The theory holds better for countries