According to the four-way equivalence model, both interest rates and inflation rates are theoretically associated with expected changes in spot rates. Your task is to review the empirical evidence relating to this assertion and determine whether these theoretical relationships have any basis in fact.
The “Four Way Equivalence Model” is a relationship between interest rates and inflation rates keeping in view the foreign exchange rates and also the changes that are expected to take place in spot rates. It gives the idea that how these things are interconnected and how increase in one factor would affect the other one and vice versa.
Machiraju (2002,75) explains the basis of this concept in these words, “In competitive markets with a large number of buyers and sellers and low cost access to information, exchange adjusted prices of tradable goods and financial assets must be equal worldwide. This law of one price is enforced by international arbitrageurs who buy low and sell high and prevent all deviations from equality. Four theoretical economic relationships emerge from arbitrage economic activity”.
Individual linking theories:
There are five individual theories which have a direct impact on this relationship mentioned and explained below:
1. Interest Rate Parity Theory - Linking interest rates and spot rates and forward foreign exchange rates
2. The Fisher Effect - Linking interest rates with expected inflation rates
3. Expectations theory - Forwarding foreign exchange rates and future out-turn spot foreign exchange rates
4. The International Fisher Effect – Dealing with interest rate differentials and expected change in spot foreign exchange rates
5. Purchasing Power Parity Theory - Explaining Inflation rate differentials and...
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...est rate to depreciate against a country with lower interest rates.
It is clearly shown that ‘Difference in Interest rates’ equals ‘Expected difference in Inflation rates’ and the ‘Expected change in spot rate’ equals ‘expected difference in inflation rates’ and ‘Difference in interest rates’. Therefore, it can be said for sure that both interest rates and inflation rates are theoretically associated with expected changes in spot rates.
References:
Frisch, H., 1983. Theories of Inflation. 1st ed. Cambridge: Cambridge University Press.
Ignatiuk, A., 2008. The Principle, Practise and Problems of Purchasing Power Parity Theory. 1st ed. Norderstedt: BoD – Books on Demand.
Machiraju, H. R. , 2002. International Financial Markets And India. 1st ed. New Delhi: New Age International.
Madura, J., 2008. International Financial Management. 19th ed. OH: Cengage Learning.
For example, if the cost of the consumer basket rises, say, from $100 in 2007 to $102 in 2008, the average annual rate of inflation for 2008 is 2 per cent. People generally believed that if the inflation rate was higher than normal in the past so they will expect it to be higher in the future than anticipated whereas some takes in consideration the past along with current economic indicators, such as the current inflation rate and current economic policies, to anticipate its future performance. Over the long term, the earnings margins of corporations are inflationary and so are the wage gains of workers. According to rational expectations, attempts to reduce unemployment will only result in higher inflation. To fully appreciate theories of expectations, it is helpful to review the difference between real and nominal concepts. Anything that is nominal is a stated aspect. In contrast, anything that is real has been adjusted for inflation. To make the distinction clearer, consider this example. Suppose you are opening a savings account at a bank that promises a 5% interest rate. This is the nominal, or stated, interest
To investigate this further I will discuss these assumptions and identify particular methods favoured in relation to two contrasting theories, ...
A theme that dominates modern discussions of macro policy is the importance of expectations, and economists have devoted a great deal of thought to expectations and the economy. Change in expectations can shift the aggregate demand (AD) curve; expectations of inflation can cause inflation. For this reason expectations are central to all policy discussions, and what people believe policy will be significantly influences the effectiveness of the policy.
People tend to try and predict what their future needs will be in order for them to be able to satisfy their current and future wants. The two-period model of intertemporal choice tries to interpret based on the current time period (e.g. this month) and a prediction of the future time period (e.g. next month) what consumers will be able to spend, borrow or save according to their levels of income and interest rates. In this assignment however we are mostly concerned on the changes of interest rate and specifically the impact an increase in the level of interest rates would have to consumers who are either savers or borrowers in the first period and how would that affect their consumption levels.
These three theories do not effectively offer an explanation
Mundell, Robert A. "A Theory of Optimum Currency Areas." The American Economic Review 51.4 (1961): 657-65. Print.
Meese, R, & Rogoff, K 1983, 'Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?', Journal Of International Economics, Vol. 14, no. 1-2, pp. 3-24.
In the articles above, there are numerous ways in which they relate to each other's perspective.
ROBINSON, Joan (1965b). “The General Theory after Twenty-Five Years”. Collected Economic Papers, vol. III, pp. 100-2.
[6] Kripalani, Majeet & Egnardio, Pete. The Rise Of India. Business Week Online. December 8, 2003. http://www.businessweek.com/magazine/content/03_49/b3861001_mz001.htm
Howells, Peter., Bain, Keith 2000, Financial Markets and Institutions, 3rd edn, Henry King Ltd., Great Britain.
the empirical relations based on the VAR test conducted for the period 1990 to 2009 show that, Money supply and inflation are weakly positively correlated, Money supply and interest rates are very weakly and negatively correlated, Money supply and real GDP are strongly positively correlated, Money supply and nominal GDP are very strongly negatively correlated. Furthermore, the response of inflation to shocks in money supply is very weakly positive or has no effect since it is constant through out. This indicates that the relationship between money supply and inflation is not too significant.
...two aspects, nominal and real, both measuring two different controls. Nominal measures what is considered a “price tag” of a loan, which includes the price of inflation. While real measures the cost of a loan without inflationary rates. From nominal and real rates there are also lowered and raised rates. When the interest rate is lowered consumer spending grows while savings decrease. Spending on items such as housing becomes one of the ways the AD rises. Though AD rises it pulls the economy out lack of spending, but puts the economy into the possibility of inflation. Differentiating from low rates, high rates stop inflation but creates the possibility of recession. High interest rates create a fall in demand for goods and services. This fall of AD puts a stop to spending, borrowing and much more, creating the incentive to save ultimately putting a haul to inflation.
A brief explanation has been explained through the end of this topic. Besides that, we also investigated theories connected to our topic whether these theories fit or not to our findings.
Daniel M. Chin., Preston J. Miller. (1998). Fixed vs. floating exchange rate: A dynamic general equilibrium analysis. European Economic Review 42 (1998),