Assume that real interest rates around the world are 3% and that PPP and the Fis
ID: 1137846 • Letter: A
Question
Assume that real interest rates around the world are 3% and that PPP and the Fisher effect both hold. Inflation in Turkey is 11% and in the Euro zone it is 2%. GDP growth is rates are 2% in both countries,
a. What will happen to the lira/euro exchange rate over the next year? b. What does the Fisher effect predict for the 2 nominal interest rates? c. How fast is the money supply growing in Turkey and the Euro zone? Use equations to solve the questions(a),(b) and (c). Please show the specific equations and process of the solutions to these three questions.
Explanation / Answer
As inflation rate in Turkey is higher than the inflation rate in Euro zone the foreign currency in Turkey will be appreciated. It means percentage change in value of foreign currency will be [(1+0.11)/(1+0.02) -1] = (1.11/1.02) - 1 = 0.088. It means foreign currency i.e Euro will be appreciated more by 8.8 percent in Turkey. Lira/Euro will depreciate by 8.8% as Euro will increase by that percentage.
B) Fisher effect predict about the two nominal interest rate is that nominal interest rate in Turkey is higher than Foreign. As a result the domestic currency will depreciate in Turkey. Because we know that according to Fisher theory is that future spot rate is differ from current spot rate by the amount of interest rate differential. So Fisher effect tells that currency in Turkey will depreciate because of nominal intetint rate in Turkey is higher than foreign.
C) As GDP growth rate in both the country is 2% then we can say money supply in Turkey is higher than money supply in foreign country. This money supply growth rate should be 2% when the GDP growth rate is 2%. As inflation rate is 11% in Turkey so we can growth of money supply is 9% higher than the foreign country.