Inflation and Exchange Risk
Let us begin by holding relative prices constant and looking only at the effects of general inflation. This condition means that if the inflation rate is, say, 10%, the price of every good in the economy rises by 10%. In addition, we will initially assume that all goods are traded in a competitive world market without transaction costs, tariffs, or taxes of any kind. Given these conditions, economic theory tells us that the law of one price must prevail. That is, the price of any good, measured in a common currency, must be equal in all countries.
If the law of one price holds and if there is no variation in the relative prices of goods or services, then the rate of change in the exchange rate must equal the difference between the inflation rates in any two countries. The implications of a constant real exchange rate—that is, that purchasing power parity (PPP) holds—are worth exploring further. To begin, PPP does not imply that exchange rate changes will necessarily be small or easy to forecast. If a country has high and unpredictable inflation (e.g., Russia), then the countrys exchange rate will also fluctuate randomly.
Nonetheless, without relative price changes, a multinational company faces no real operating exchange risk. As long as the firm avoids contracts fixed in foreign currency terms, its foreign cash flows will vary with the foreign rate of inflation. Because the exchange rate also depends on the difference between the foreign and the domestic rates of inflation, the movement of the exchange rate exactly cancels the change in the foreign price level, leaving real dollar cash flows unaffected.
Application Calculating the Effects of Exchange Rate Changes and Inflation on Apex Philippines
Apex Philippines, the Philippine subsidiary of Apex Company, produces and sells medical imaging devices in the Philippines. At the current peso exchange rate of P 1 = $0.01, the devices cost P 40,000 ($400) to produce and sell for P 100,000 ($1,000). The profit margin of P 60,000 provides a dollar margin of $600. Suppose that Philippine inflation during the year is 20%, and the U.S. inflation rate is zero. All prices and costs are assumed to move in line with inflation. If we assume that purchasing power parity holds, the peso will devalue to $0.0083 [0.01 X (1/1.2)]. The real value of the peso stays at $0.01 [0.0083 X (1.2/1.0)], so Apex Philippines’s dollar profit margin will remain at $600. These effects are shown in Exhibit 11.2.