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EXCHANGE RATES AND INFLATION

The financial manager of an international business must cope with fluctuations in exchange rates and must be aware of the distinction between spot and forward exchange rates. She must also recognize that two countries may have different interest rates. To develop a consistent international financial policy, the financial manager needs to understand how exchange rates are determined and why one country may have a lower interest rate than another. These are complex issues, but as a first cut we suggest that you think of spot and forward exchange rates, interest rates, and inflation rates as being linked as shown in Figure 6.1. Let`s explain.

EXCHANGE RATES AND INFLATION

Consider first the relationship between changes in the exchange rate and inflation rates (the two boxes on the right of Figure 6.1). The idea here is simple: if country X suffers a higher rate of inflation than country Y, then the value of X`s currency will decline relative to Y`s. The decline in value shows up in the spot exchange rate for X`s currency. But let`s slow down and consider why changes in inflation and spot interest rates are linked. Think first about the prices of the same good or service in two different countries and currencies.

Suppose you notice that gold can be bought in New York for $300 an ounce and sold in Mexico City for 4,000 pesos an ounce. If there are no restrictions on the import of gold, you could be onto a good thing. You buy gold for $300 and put it on the first plane to Mexico City, where you sell it for 4,000 pesos. Then (using the exchange rates from Table 6.5) you can exchange your 4,000 pesos for 4,000/9.438 = $424. You have made a gross profit of $124 an ounce. Of course, you have to pay transportation and insurance costs out of this, but there should still be something left over for you.

You returned from your trip with a sure-fire profit. But sure-fire profits don`t exist ¤ not for long. As others notice the disparity between the price of gold in Mexico and the price in New York, the price will be forced down in Mexico and up in New York until the profit opportunity disappears. This ensures that the dollar price of gold is about the same in the two countries.

Gold is a standard and easily transportable commodity, but to some degree you might expect that the same forces would be acting to equalize the domestic and foreign prices of other goods. Those goods that can be bought more cheaply abroad will be imported, and that will force down the price of the domestic product. Similarly, those goods that can be bought more cheaply in the United States will be exported, and that will force down the price of the foreign product.

This conclusion is often called the law of one price. Just as the price of goods in Safeway must be roughly the same as the price of goods in A&P, so the price of goods in Mexico when converted into dollars must be roughly the same as the price in the United States:

Dollar price of goods in USA = peso price of goods in Mexico number of pesos per dollar $300 = peso price of gold in Mexico 9.438

Price of gold in Mexico = 300 ГЧ 9.438 = 2,831 pesos

No one who has compared prices in foreign stores with prices at home really believes that the law of one price holds exactly. Look at the first column of Table 6.6, which shows the price of a Big Mac in different countries in 1999. Using the exchange rates at that time (second column), we can convert the local price to dollars (third column). You can see that the price varies considerably across countries. For example, Big Macs were 60 percent more expensive in Switzerland than in the United States, but they were about half the price in Malaysia.3

This suggests a possible way to make a quick buck. Why don`t you buy a hamburgerto- go in Malaysia for $1.19 and take it for resale to Switzerland where the price in dollars is $3.97? The answer, of course, is that the gain would not cover the costs. The law of one price works very well for commodities like gold where transportation costs are relatively small; it works far less well for Big Macs and very badly indeed for haircuts and appendectomies, which cannot be transported at all.

LAW OF ONE PRICE Theory that prices of goods in all countries should be equal when translated to a common currency.