Prices, Interest Rates, and Exchange Rates in Equilibrium

“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