Chapter 26: Problem 21

Brazil's Overvalued Real The Brazilian real has appreciated 33 percent against the U.S. dollar and has pushed up the price of a Big Mac in Sao Paulo to $\$ 4.60,$ higher than the New York price of $\$ 3.99 .$ Despite Brazil's interest rate being at 8.75 percent a year compared to the U.S. interest rate at near zero, foreign funds flowing into Brazil surged in October. Source: Bloomberg News, October 27,2009. Does interest rate parity hold? If not, why not?

Short Answer

Expert verified

Interest rate parity does not hold because the Brazilian real is overvalued, and high foreign investments are flowing into Brazil despite its high-interest rates.

Step by step solution

- Understand Interest Rate Parity (IRP)

Interest Rate Parity (IRP) is a theory which suggests that the difference in national interest rates for securities of similar risk and maturity should be equal to the difference between the forward exchange rate and the spot exchange rate.

- Look at Spot Exchange Rates and Interest Rates

The real has appreciated 33% against the U.S. dollar. Also, note the domestic interest rate for Brazil is 8.75% and the U.S. interest rate is near 0%.

- Compare the Prices of Big Mac

Prices of Big Mac in different countries can be used for an informal check of purchasing power parity (PPP). In Brazil, a Big Mac is priced at $4.60, while in the US it's $3.99. This suggests that the Brazilian real might be overvalued since the price is higher in Brazil.

- Determine Whether IRP Holds

Given the significantly higher interest rate in Brazil (8.75%) compared to the US (near zero), and the fact that the real has appreciated substantially, the fundamentals of interest rate parity do not appear to hold in this scenario. Large capital inflows into Brazil, despite the high interest rate, support this observation.

- Conclusion

Interest rate parity does not hold. The overvalued real and substantial capital inflows into Brazil suggest that other factors, such as investor sentiment or expected economic growth, are influencing exchange rates and capital movements more strongly than interest rate differentials.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Understanding Exchange Rates

Exchange rates determine how much one currency is worth compared to another. They play a crucial role in international trade and finance. For example, if the Brazilian real appreciates against the U.S. dollar, it means you need more U.S. dollars to buy the same amount of reals.
Factors that influence exchange rates include:

Interest rates
Inflation rates
Economic stability
Political stability

Exchange rates can fluctuate due to market speculation, economic data releases, and geopolitical events. When the real appreciated by 33% against the dollar, it became more expensive in relation to the U.S. dollar.

Exploring Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a basket of goods approach. PPP suggests that in the absence of transportation and other transaction costs, identical goods should have the same price across different countries when expressed in a common currency.
For example:

If a Big Mac costs $\text{ USD } 4.60 $ in Sao Paulo and $\text{ USD } 3.99 $ in New York, the PPP suggests that the real might be overvalued because you're paying more for the same product in Brazil.

PPP is an informal way to gauge currency valuation and provides insights into whether a currency is overvalued or undervalued.

The Role of Capital Flows

Capital flows refer to the movement of money for investment, trade, or business production across countries. These flows can greatly influence a country's exchange rate and overall economic health. Capital inflows into Brazil increased in October despite the high-interest rates.
Some key aspects of capital flows include:

Foreign Direct Investment (FDI)
Portfolio Investment
Loans

Foreign investors might be attracted to high returns, which explains the influx of capital into Brazil despite their high interest rates.

Interest Rates Explained

Interest rates are the amount charged by lenders to borrowers for the use of money, expressed as a percentage of the principal. They are a critical tool used by central banks to manage economic activity.
Important points about interest rates:

Higher interest rates can attract foreign investment because they offer better returns on investments.
Lower interest rates typically stimulate borrowing and spending in the economy.

In Brazil, the interest rate was 8.75%, much higher than the near-zero rate in the U.S., which typically would attract investors seeking higher returns.

Appreciation and Depreciation of Currencies

Currency appreciation and depreciation refer to the increase or decrease in a currency's value relative to another currency.

Appreciation: When a currency increases in value, making it more expensive compared to others. For example, the real appreciated by 33% against the U.S. dollar.
Depreciation: When a currency decreases in value, becoming cheaper relative to other currencies.

Appreciation can make exports more expensive and imports cheaper, while depreciation has the opposite effect. Other factors like interest rates and economic performance also play a significant role in currency fluctuation.