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.
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.
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