Question

Answer the following questions regarding PPP and the IFE. Assume that the nominal interest rate in Mexico is 48% and the interest rate in the United States is 8% for 1-year securities that are free from default risk. a. What does the IFE suggest about the differential in expected inflation in these two countries? (10 points) b. Using this information and the PPP theory, what is the expected nominal return to U.S. investors who invest in Mexico? Assume that the real interest rates in Mexico and the United States are 10% and 3%, respectively

Answer 1

a)

Nominal Interest Rate in Mexico = 48%

Nominal Interest Rate in US = 8%

The international Fisher effect (IFE) says that differences in nominal interest rates reflect expected changes in the spot exchange rate between countries.

In general, if the nominal rate of a country is higher than other country, its currency will depreciate against the currency of that country. Higher nominal rate means higher inflation and depreciated currency.

So Mexican Peso will depreciate since it has higher nominal rate.

b

According to PPP, rate of change of prices (which is inflation) of the same basket of products in different countries should be similar when measured in common currency.

Real Rate in Mexico = 10%

Real Rate in US = 3%

Nominal rate = Real rate + inflation

So Inflation = Nominal rate - real rate

So Inflation in Mexico = 48 - 10 = 38%

Inflation in US = 8 - 3 = 5%

Differencial in inflation = 33%

According to PPP, the Mexican peso should depreciate by the amount of the differential between U.S. and Mexican inflation rates i.e . 33%. So the Mexican peso should depreciate by about 33 percent. Given a 48 percent nominal interest rate in Mexico and expected depreciation of the peso of 40 percent, U.S. investors will earn about 15 percent.