FINAL YEAR PROJECT ON DETERMINATION OF THE EXCHANGE RATE FLUCTUATIONS BETWEEN COUNTRIES BY DEBARATI KUNDU ROLL NO: PC/AEC/1006

M.SC 2nd YEAR APPLIED ECONOMICS 2009-2011 UNDER SUPERVISION OF EXTERNAL: AMITAVA SARKAR
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INTERNAL: GAGARI CHAKRABARTI

ACKNOWLEDGEMENT
It is an incidence of great pleasure in submitting this Project Report. This project is a complete source of information to me. This project has been a great learning experience for me and I would like to express my gratitude towards all the people who have guided me throughout and without whose guidance this project cannot be so informative. I would like to extend my sincere thanks and heartfelt gratitude to my external Professor Amitava Sarkar (Professor and Director at its School of Management, West Bengal University of Technology (WBUT) and Professor Gagari Chakrabarti (PhD, Professor of Economics, Department of Economics, Presidency College) for not only helping me and providing me with all the required information regarding my project work but also for giving valuable suggestions, invaluable advice and support that I needed on all aspects of the project. The project would not have been complete without their support and guidance. I am personally indebted to my college and the Head of the Economics Department, Professor Amitava Chatterjee for his guidance, support and advice throughout the tenure and also whose practical knowledge and experience has helped me to understand
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the project and to relate it in practical field during the course of the project.

(DEBARATI KUNDU)

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DECLARATION
I, DEBARATI KUNDU, student of M.SC APPLIED ECONOMICS from PRESIDENCY COLLEGE, KOLKATA (2009-2011) batch declare that every part of the Project DETERMINATION OF EXCHANGE RATE FLUCTUATIONS BETWEEN COUNTRIES that I have submitted is original.

Date of project submission: 16.6.2011

DEBARATI KUNDU Signature of the student

Facultys Comments

Signature of Faculty guide

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ABSTRACT
The success or the failure of an open economy depends crucially on the management of its exchange rate where exchange rate of the domestic currency is an important link between the domestic economy and the world. When the country has flexible exchange rate regime, the domestic economy is expected to adjust whenever exchange rate changes. Hence for the economy to adjust, macroeconomic variables like interest rates and inflation rates are generally used by the government to determine the effect of fluctuations of the exchange rates on the economy and to control the volatility that follows due to the fluctuations. We use Purchasing Power Parity (PPP), Fisher Effect and International Fisher Effect (IFE) to analyze the direct effect of a interest rate differential on the exchange rate change, the direct effect of an inflation rate change on exchange rate change and the indirect effect of a change in interest rate and inflation rate on exchange rate fluctuations between developed and developing countries, over a thirteen year period from 1997-2010. The period is divided into the crisis period of 1997-2000, post crisis period of 2001-2006 and the economics crisis of 2007-2010. We applied GARCH method on the monthly data for the interest rates, inflation rates, and exchange rates for four countries, namely, USA, Japan, Brazil, and India based on their economic development and industrialization. The results significantly determined the presence of Fisher Effect between developed and developing countries in all the crisis period. However inflation rate differential and interest rate differential did not directly or indirectly determine exchange rate fluctuations between Japan and Brazil and Japan and India as IFE and PPP did not hold in the periods. IFE had a significant negative effect for US and Japan in all the three periods but PPP had no effect in the two crisis periods and had a positive effect in the post crisis period for US and Japan. So inflation rates differential between Japan and US indirectly determined the exchange rate fluctuations through interest rates. For both India and Brazil in relation with US, IFE had a positive effect in 1997-2000, no effect in 2001-2006 and a negative effect
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in 2007-2010 due to the economic crisis, whereas PPP had a positive effect in 1997-2000, negative effect in 2001-2006 and no effect in the economic crisis. So exchange rate fluctuations were directly affected by interest rates changes in India and Brazil compared to US and indirectly by inflation rate changes in the period 2007-2010.

I.

INTRODUCTION

Economic activity is globally unified today to an unprecedented degree. Changes in one nations economy are rapidly transmitted to that nations trading partner. These fluctuations in economic activity are reflected almost immediately in fluctuations in currency values and the multinational corporations, with their integrated cross border production and marketing operations, continually face devaluation or revaluation problems. This risk associated with the currency is due to the fluctuations in the exchange rate. Exchange rate is simply the price of one nations currency in terms of another currency. They are market clearing prices that are determined by supply and demand for a currency in the foreign exchange market. In an effort to free international trade and fund postwar reconstruction, the Bretton Woods system, established in 1944, created an international basis for exchanging one currency for another and since the United States at the time accounted for over half of the world's manufacturing capacity and held most of the world's gold, the leaders decided to tie world currencies to the dollar, which, in turn, they agreed should be convertible into gold at $35 per ounce. Under the Bretton Woods system, central banks of countries other than the United States were given the task of maintaining fixed exchange rates between their currencies and the dollar by intervening in foreign exchange markets. However the Bretton Woods system lasted until 1971 as inflation and a growing American trade deficit were undermining the value of the dollar. Americans urged Germany and Japan, both of which had favorable payment balances, to appreciate their currencies but those nations were reluctant since raising the value of their currencies would increase prices
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for their goods and hurt their exports. Finally, by 1973, the United States and other World nations agreed to allow exchange rates to float freely against dollar and severed the link between the dollar and gold. Floating exchange rates reflect the speculative dynamics of the market. Economic shocks such as a steep rise in international interest rates, a slowdown of growth in the industrial world, and the debt crisis often require currency depreciations and the adoption of more flexible exchange rate regimes. The increased capital mobility and waves of capital inflows and outflows have heightened the potential for shocks and the pressure for flexibility of exchange rate and hence associate risk with it transactions.

II.

DETERMINANATS OF EXCHANGE RATE FLUCTUATIONS

Numerous factors determine exchange rate fluctuations, and all are related to the trading relationship between two countries. Exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries.

Factors Affecting Foreign Exchange Rate Fluctuations Rise in the National Income rise in the demand for Currency
Rise in Interest Rates rise in the demand for Currency Rise in Inflation Rates rise in the Demand for Currency Rise in National Wealth ( increase in Current Account) rise in the demand for Currency Fall in Financial Risk rise in the Demand for Currency Fall in Political Risk rise in the demand for currency Rise in the demand of Currency rise in the price of Currency

Before we look at these forces, we should sketch out how exchange rate movements affect a nation's trading relationships with other nations. A

higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports
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cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase it. 1. Differentials in Inflation A country with a high supply of its currency relative to its demand will result in a high inflation rate due to the rise in the price of the products and exports will decrease as people will buy less and imports will increase with respect to another country. This result in a decline in the amount of the currency supplied and an increase in the demand for that currency compared to other currencies. Hence those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. 2. Differentials in Interest Rates Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. 3. Current-Account Deficits The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than
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foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4. Public Debt Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason behind this is that a large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future. In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating is a crucial determinant of its exchange rate. 5. Terms of Trade A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increases in the terms of trade show a greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's
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value will decrease in relation to its trading partners. 6. Political Stability and Economic Performance Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries. A large number of models have been developed in the literature to explain the fluctuation of the exchange rate. Here in this project we use inflation rate differential and interest rate differential between the countries as factors to determine the effect of change in exchange rate between developed and developing countries over the period of 1997-2010. This is been well explained through the parity conditions.

III.

PARITY CONDITIONS

Parity conditions are an explanation for the long-run value of exchange rates where a set of equilibrium relationships are applied to product prices, interest rates and exchange rates assuming that there is no market intervention. However these relationships depend on arbitrage and the law of one price which underlies the globalization of the markets. The law of one price assumes that in competitive markets characterized by numerous buyers and sellers having low cost access to information, exchange adjusted prices of identical tradable goods and financial assets must be within transactions costs worldwide. Similarly in the absence of market imperfections, risk adjusted expected returns on financial assets in different markets should be equal. The parity conditions that rise from arbitrage include: 1) Purchasing power parity 2) Fisher effect 3) International fisher effect 4) Interest rate parity and 5) Unbiased Forward rate. These conditions are

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linked by the fact that various rates and prices are adjusted to inflation and money should have no effect on real variables as they are adjusted.

UFR PPP

IFE

IR FE Purchasing Power Parity

Relative Purchasing power parity (PPP) states that over the long-run the exchange rate between two currencies adjusts to changes in the relative price levels of the two countries. Absolute purchasing power parity states price levels should be equal worldwide when expressed in a common currency. If e t is the spot exchange rate at the end of one period over the spot exchange rate at the beginning of the period e0 and if and ih are rates of inflation for foreign and home country respectively then,

et 1 A simplified version of PPP is given as: = ih i f (2) e0 PPP says the currency with the higher inflation rate is expected to
depreciate relative to the currency with the lower rate of inflation where exchange rate is defined as domestic currency per unit of foreign currency.

et (1 + i h ) = e0 (1 + i f ) t
t

et = e 0

(1 + i h ) t (1 + i ) t

(1)

FISHER EFFECT
Fisher effect states that that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations : r = a + i. (3)

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The generalized version of fisher effect asserts that real interest rate are equalized across countries through arbitrage that is if expected real returns were higher in one currency than another, capital would flow from the second country to the first till expected real returns are equalized in absence of government intervention. Hence in equilibrium, with no government intervention, it should follow that nominal interest rate differential will equal the anticipated inflation differential between two currencies. rh rf = ih - if (4)

According to the Fisher Effect, countries with currencies having higher inflation rates have higher interest rates than currencies having lower inflation rates.

International Fisher Effect

To understand the impact of relative changes in nominal interest rates among countries on foreign exchange value of a nations currency is to combine the effects of PPP and FISHERS EFFECT. Hence international fisher effect states that the spot exchange rate adjusts to the interest rate differential between two countries. et (1 + rh ) t

e0

(1 + r f ) t
rf = (e1 -

(5) e0 )/e0

Simplified IFE equation: (if rf is relatively small) : rh -

.Hence IFE implies that currencies with the lower interest rate are expected to appreciate relative to one with a higher rate and financial market arbitrage insures interest rate differential is an unbiased predictor of change in future spot rate. Hence, the IFE theory concludes

that when home interest rate is higher than foreign interest rate, the foreign currency value will be positive, since the relatively low foreign interest rate reflects relatively low inflationary expectations in the foreign country. The foreign currency will then appreciate, as the foreign interest rate will be lower than the domestic interest rate. This appreciation would then increase the foreign returns to investors in the home country, thereby moving returns on foreign securities close to returns on home securities. If, on the other hand, when home interest rate is lower than foreign interest rate, the foreign currency value will be negative, because the foreign currency will depreciate when the foreign interest rate
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exceeds the domestic interest rate. This depreciation will tend to reduce the returns on foreign financial securities and make them unattractive to domestic investors in the financial securities in the home country money market to yield higher returns.

INTEREST RATE PARITY

Interest rate parity uses nominal interest rates to analyze the relationship between spot rate and a corresponding forward rate. It relates interest rate differentials between home country and foreign country to the forward premium/discount on the foreign currency. If nominal interest rates are higher in country A than country B, the forward rate for country Bs currency should be at a premium sufficient to prevent arbitrage. According to IRP:
F (1 + rh ) = S (1 + r f )

(6)

Where F is the forward rate, S is the spot rate and rh and rf are the interest rates for home and foreign country respectively. Thus, F is less than S, if rf > rd and F is more than S, if rf < rd. If IRP holds, arbitrage is not possible; it does not matter whether you invest in domestic country or foreign country, your rate of return will be the same as if you invested in home country when measured in domestic currency. The implications of interest rate parity are
If domestic interest rates are less than foreign interest rates, foreign

currency must trade at a forward discount to offset any benefit of higher interest rates in foreign country to prevent arbitrage. If foreign currency does not trade at a forward discount or if the forward discount is not large enough to offset the interest rate advantage of foreign country, arbitrage opportunity exists for domestic investors. Domestic investors can benefit by investing in the foreign market.
If domestic interest rates are more than foreign interest rates, foreign

currency must trade at a forward premium to offset any benefit of higher interest rates in domestic country to prevent arbitrage. If foreign currency does not trade at a forward premium or if the forward
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premium is not large enough to offset the interest rate advantage of domestic country, arbitrage opportunity exists for foreign investors. Foreign investors can benefit by investing in the domestic market.

Unbiased Expectations Hypothesis

The unbiased expectations hypothesis is the theory that forward exchange rates are unbiased predictors of future spot rates. This hypothesis assumes that there is no uncertainty about inflation. The unbiased expectations hypothesis also assumes that investors are risk neutral and that exchange rate can be ignored for the determination of the future spot rate. It states that if the forward rate is unbiased, then it should reflect the expected future spot rate where ft = et. There has been a tremendous growth of the literature on exchange rate in the past two decades. The success or failure of an open economy depends crucially on the management of its exchange rate. Given this importance it is no wonder that exchange rate is one of the heavily researched areas in the economics literature. In case of an open economy the exchange rate of the domestic currency is the crucial link between the domestic economy and the world. When the country is having a flexible exchange rate regime, the domestic economy is expected to adjust whenever exchange rate changes. Hence for the economy to adjust, macroeconomic variables like interest rates and inflation rates are generally used by the government to determine the effect of fluctuations of the exchange rates on the economy and to control the volatility that affects the economic growth between countries. Therefore among the parity conditions, we use Purchasing Power Parity, Fisher Effect and International Fisher Effect to analyze the direct effect of an interest rate differential on the exchange rate change, the direct effect of an inflation rate change on exchange rate change and the indirect effect of an interest rate change and inflation rate change on exchange rate fluctuations. To understand how changes in interest rates and inflation rates influence and controls exchange rate volatility, we have decided to interpret it in
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terms of developed and developing countries. In this project, our main aim is to determine how inflation rate changes and interest rate changes between developed-developed countries, developed-developing countries and developing-developing countries affect the exchange rate fluctuations directly or indirectly. Hence we have taken four countries, developed countries of United States of America and Japan and developing countries of India and Brazil over a period of 1997-2010. We divided the period into the Asian crisis of 1997-2000, the recovery period of 2001-2006 and the economic crisis of 2007-2010 and tried to analyze the relations between exchange rate, inflation rate and interest rate changes in both the crisis and in the recovery periods.

IV.

LITERATURE SURVEY
to determine the influence of interest rate

Recently there have been many studies of the International Fisher Effect and the Fisher Effect theories differential and inflation rate differential on exchange rate changes and on each other, such as the research by Crowder (2003), who used data from several sources for his studies. These sources included the OECD Main Economic Indicators, monthly observations on short-term nominal interest rates and CPI inflation data. The study focused on eight industrialized countries and covered a period of over three decades from January 1960 to August 1993. The interest rates and inflation rates were converted to annualized values. The Belgian interest rate was the three-month treasury certificates. The German interest rate was the FIBOR rate. The French, British and Dutch nominal interest rates were the call money rates. The Italian rate used was the Treasury bond rate with a 6-year average maturity. The Japanese and American nominal interest rates used were three-month Treasury bill rates. He analyzed the Fisher relation for these industrialized countries over the study period using regression analysis. He found clear evidence that supports the Fisher theory in all the eight countries. In recent years, the development of new and more powerful econometric methods has rekindled empirical work into the validity of
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Fisher effect. Mishkin (1992) employed the Engle-Granger error-correction mechanism to test for the effect in US, while Hawtrey (1997) and Daniels et al (1996) have separately applied Johansens method to Australian data. Both latter works have yielded support for the existence of the Fisher effect. Payne and Ewing (1997) applied a similar approach to the data of nine less developed countries (LDCs) and their results showed that five of the countries display no sign of a long run Fisher effect, while three of them provided convincing evidence of it. The International Fisher Effect by Sundqvist (2002), involved empirical studies using quarterly data for the nominal interest rates and exchange rates from different industrialized countries over the period between 1993 and 2003. For the study, he selected Sweden, Japan, UK, Canada, and Germany, countries with floating exchange rates, for a comparative study with the US. He used regression analysis to examine the nominal interest differentials and the exchange rates change in these countries. He concluded that the International Fisher Effect was only valid for the US and Japan. Mishkin (1984) studied the real interest rate movements in seven OECD countries for the period 1967 to 1979 in the euro deposit market. He found a close relationship between nominal interest rates and expected rates of inflation for the UK, the US and Canada. He found that Germany, the Netherlands, and Switzerland exhibited much weaker Fisher effect. Meanwhile, the research of Mishkin and Simon (1995), using data spanning the period 19621993, found evidence of a long-run Fisher relationship, but with no short-run effect. A paper by Antnio Portugal Duarte, Faculty of Economics - University of Coimbra and Group for Monetary and Financial Studies applied Purchasing Power Parity (PPP) theory to the analysis of long-run equilibrium in the foreign exchange market where he studied the case of Portugal vis--vis Germany and Spain, and the case of Spain vis--vis Germany, in the period 1960-1990. The empirical analysis was based on unit-root testing (using ADF tests) and Johansens methodology for the study of cointegration. He worked with linear long-run relationships based exclusively
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on PPP, as well as with long-run relations that also allowed for the effect of interest rates. In a situation in which PPP does not hold, one could think that on account of some natural reason agents believe that, as time goes by, the dominant currency, which is also the reference currency of the EMS (the German Mark), will appreciate. He concluded, on the contrary, that the weaker currencies were the ones that with the passing of time appreciated in real terms. The paper by Siti Rahmi Utami of Maastricht School of Management tests and analyses the influence of interest rate differential on exchange rate changes based on the International Fisher Effect theory and the influence of inflation rate and interest rate differentials in Indonesia. To test this theory, he use quarterly and yearly data for the interest rates, inflation rate differentials, and changes in exchange rates over a five-year period, 2003-2008. We chosen for our study four foreign countries, namely, the USA, Japan, Singapore, and the UK, based on their levels of economic development and industrialization, and Indonesia as the home country. Regression results showed that interest rate differentials have positive but no significant influence on changes in exchange rate for the USA, Singapore, and the UK relative to that of Indonesian. On the other hand, interest rate differentials have negative significant influence on changes in exchange rates for Japan. Regression results also showed that, overall, inflation rate differentials have positive significant influence on interest rate differential. The paper by Hammad Ul Haq Mughal and Yasir Kamal empirically investigate the performance of GARCH family models in forecasting the volatility behavior of Pakistani exchange rate market by using the models of symmetric GARCH-M model and asymmetric EGARCH and TARCH models. Pakistan had adopted the floating exchange rate since 1982. The daily representative exchange rates data ranging from Jan-2000 to Dec2008 is used to study the volatility behavior. The GARCH-M and EGARCH models show the first order autoregressive behavior in the exchange rate. The GARCH-M model supports that past day exchange rate affects the
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current day exchange rate. EGARCH results that there is existence of asymmetric behavior in volatility, while the TARCH model remains insignificant. This study deserves a continuous research on this area to reach an ultimate conclusion about the long term behavior of exchange rate in the developing countries like Pakistan with the use of certain new advanced models to support the evidence. The exchange rate plays vital role in the financial market and its importance is increasing in the developing economies. Exchange rate volatility is an important factor to consider in decision making by the investors as the interest of global investment community is increasing in assets market and in international portfolios. The volatility information is also helpful in acquainted policy making related to certain macroeconomic decisions. The historical record of certain financial crises in the history further ads up to the importance of volatility in exchange rate markets. Hence in this project we have analyzed the effect of interest rate and inflation rate changes on determining the exchange rate changes between the developed-developed, developed-developing and developingdeveloping countries from one financial crisis to the other using GARCH models.

V.

DATA SAMPLE

We have chosen 4 countries for our study US, Japan, India and Brazil. The reason for taking these four countries is based on the economic development, trade relations and industrialization. US and Japan are
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developed countries whereas Brazil and India are the two fastest growing economies and there is a strong trade relations between them. The Asian crisis of 1997 and the IT shock of 2009-2010 have witnessed a change in the macroeconomic variables of Japan whereas the housing bubble in United States in 2007 led to the worst economic crisis which had a contagion effect on all the countries that had trade relations with US leading to unemployment, high inflation and current account deficit. Hence we tried to analyze whether exchanges rate changes in one country affects the exchange rate in the other through interest rate differential and inflation rate differentials between countries. We have collected macroeconomic data from the OECD (Organization for economic co operation and development) from 1997 to 2010. We use the monthly data for nominal exchange rates, inflation rates and nominal interest rates from 1997 to 2010 where the data on inflation rates were collected as the monthly inflation rates in percentages from previous periods and the interest rates were immediate interest rates, Call Money, Interbank Rate, per cent per annum which was made monthly for all the four countries. The period of 1997-2010 was divided into the crisis region of 1997-2000, the post crisis region of 2001-2006 and the economic crisis of 2007-2010 and using the three parity conditions of International Fisher Effect, Fisher Effect and Purchasing Power Parity, we tried to find out how exchange rate changes between countries were controlled by the economies using interest rate differential and inflation rate differential by using GARCH method.

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VI.

METHOD OF ESTIMATION

ARCH/GARCH Models The ARCH/GARCH models have become standard tools for questions about volatility. The assumption of homoscedasticity, that the squared expected values of all error terms at any given point are equal, is the focus of ARCH/GARCH models. Heteroscedasticity is a problem where the variances of the error terms are not equal and thus are expected to be larger for some ranges. ARCH/GARCH models treat heteroscedasticity as a variance to be modeled. The simplest specification of the conditional variance is the ARCH model, in which the conditional variance is simply the weighted average of past squared forecast errors. In the following ARCH equation (p) represents past squared forecast errors.

t2+1 = + 1e t2 + 2e t21 +... + pe t2 p 1

(7)

A generalization is to allow past conditional variance to enter the equation, this brings us to the Generalized ARCH (GARCH) equation. This generalization was introduced by Bollerslev (1986). This model used the weighted average of past squared residuals, but has declining weights that never go to zero. (Engle, 2001) In the following GARCH equation (p) represents the number lags for the squared error terms and (q) represents the past variances.

t2+1 = + 1et2 + 2et21 +... + pet2 p + 1 t2 +... + q t2 1 q

(8)

The most widely used GARCH specification, GARCH (1, 1), states that the best predictor of the variance in the next period is the weighted average of the long-run average variance (the variance predictor for this period), and new information is captured by the most recent squared residual. The simplified GARCH (1, 1) model is shown below

ht = + 1 21 + 1ht 1 . t
(9)

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The variance (ht) is a function of an intercept ( ), a shock from the prior period ( ) and the variance from last period ( ).

VII.

METHODOLOGY

We have divided the period from 1997 to 2010 into three periods. The Asian crisis of 1997 followed by the IT shock in 1999-2000 as one period, the post crisis period of 2001 to 2006 and the major economic crisis of 2007 to 2010. We have taken two countries at a time and by using the monthly data of nominal interest rate, nominal exchange rates and inflation rates in percentages, we computed the interest rate differential, inflation rate differential and exchange rate differential between the countries, given in the appendix. This is a time series data ranging from 1997 to 2010 and Eviews is the software that is used to analyze the results. The countries are combined as developing-developing, developing developed and developed developed such US-Japan, US-Brazil, USIndia, Japan-India, Japan Brazil and India-Brazil. After computing all the differentials we checked whether the series are stationary or not using the correlogram and found out that except exchange rate differential between the countries, interest rate differential and inflation rate differentials were integrated of order 1. Here co integration, Vector autoregressive process and Granger Causality could not be used due to the non stationary of inflation rates and interest rate differentials and stationarity of exchange rate differentials. So we run descriptive statistics and apply GARCH model. Using the mean equation and the appropriate lag structure to find out the direct dependence of inflation rate differential on interest rate differential and vice versa between countries based on Fisher Effect, the dependence of interest rate differential on exchange rate differential and vice versa based on International Fisher Effect and the relation between inflation rate differential and exchange rate differential and vice versa based on purchasing Power Parity in the three periods.
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VIII.

RESULTS

Developed Developed country: US JAPAN FROM 1997 TO

2010: JAPAN HOME COUNTRY, US FOREIGN COUNTRY

FISHER EFFECT:

rh

r f = ih - if

( r is nominal interest

rate, i is inflation rate) YEAR rh - rf = ih -if 1997 -2000 Positive relation holds. An increase in inflation rate in US will cause a lower interest rates Japan. Positive relation holds. An increase in interest rate in US will cause an increase in inflation rates in US than Japan. Interest rate changes are caused due to inflation rate differential and vice versa. 2001- 2006 AN increase in inflation rate in US will cause an increase in interest rates in US and lower interest rates in Japan. AN increase in interest rate in US will cause an increase in inflation rates in US and lower inflation rates in Japan. Interest rate changes are caused due to inflation differential and vice versa 2007-2010 AN increase in inflation rate in US will cause an increase in interest rates in US and lower interest rates in Japan. AN increase in interest rate in US will cause an increase in inflation rates in US and lower inflation rates in Japan Interest rate changes are caused due to inflation differential and vice versa Net result Fisher effect holds in all the three periods

ih -if = rh - rf

Fisher effect holds in all the three periods

Net result

A high inflation rate in US was persistent in all the three periods than Japan which raised interest rates in US.

INTERNATIONAL FISHER EFFECT: (e0 -e1)/e0 = rh - rf

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YEAR (e1- e0 )/e0

rh - rf rh -rf e0 )/e0 Net result =(e1

1997-2000 Significant negative relation exists

2001-2006 No relation exists

2007-2010 Significant positive impact exists

NET RESULT IFE HOLDS ONLY IN THE CRISIS PERIOD

- No relation exists An increase in interest rate in US lead to an appreciation of Dollars and a depreciation of Yen

No relation exists Change in interest rate between US and Japan has no impact on exchange rate differential between them.

No relation exists An increase in interest rate in US lead to an depreciation of Dollars and a appreciation of Yen

IFE DOESNOT HOLD IN ANY OF THE PERIODS. Interest rate rise in US lead to the appreciation of Dollars and a depreciation of Yen in 1997-2000 but lead to a depreciation of Dollars and an appreciation of Yen in 2007-2010.

PURCHASING POWER PARITY: (e0 -e1)/e0 = ih - rf

1997-2000 No relation holds 2001-2006 No relation holds No relation exists 2007-2010 No relation exists No relation exists. NET RESULT PPP does not hold in any period. No effect of a change in exchange rate on inflation rate change. Any change in inflation rates in US does not directly create any change in the exchange rate between them.

YEAR (e1-e0 )/e0 ih - if

ih - if =(e1- No relation exists e0 )/e0

Net result

Changes in inflation rate in US do not lead to any change in Dollars and Yen and vice versa.

Changes in inflation rate in US do not lead to any change in Dollars and Yen and vice versa.

Changes in inflation rate in US do not lead to any change in Dollars and Yen and vice versa.

INTERPRETATION:

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From 1997 to 2010, there has been an increase in inflation rate in US compared to Japan as US maintained high inflation rates in the crisis and post crisis region and in order to prevent the increase in inflation, it lead to a direct increase in interest rate in US and lowered interest rates in Japan (Fisher Effect). However from the Purchasing power parity it is found that a inflation in US did not lead to any direct change in the exchange rate between US and Japan in any of the period but due to the International Fisher effect, high interest rates in US directly lead to an appreciation of exchange rate between US and Japan (appreciation of dollars) in 1997-2000 and a depreciation in exchange rate between US and Japan (depreciation of dollars) in 2007-2010. So a high inflation rate in US indirectly caused a change in the exchange rate in the crisis periods through the interest rates.

FIGURE DEVELOPED DEVELOPING STRUCTURE: US INDIA 1997 TO

2010:US FOREIGN COUNTRY, INDIA: HOME COUNTRY)

YEAR

INTERNATIONAL FISHER EFFECT: (e0 -e1)/e0 = rh - rf

1997-2000
=

2001-2006

2007-2010

NET RESULT

(e1- e0 )/e0 rh - rf

No relation exists

No relation exists

rh -rf e0 )/e0

=(e1

- Exchange rate change between India and US

No relation exists

Significant negative impact exists. Rise in interest rate in India appreciates the Rupee Exchange rate change between India and US

IFE holds only in the 2007-2010.

Exchange rate differential between US and India creates 24 | P a g e

Net result

creates a significant positive impact on interest rate differential. A rise in exchange rate (depreciation of Rupee) creates an increase in interest rates in India.

Change in interest rate between US and Japan has no impact on exchange rate differential between them.

creates a significant negative impact on interest rate differential. An increase in interest rate in India lead to a depreciation of Dollars and an appreciation of Rupee, depreciating exchange rate and vice versa.

an impact on the interest rate differential only in the crisis periods. Interest rate rise in India leads to the depreciation of exchange rate in 2007-2010 but exchange rate differential between them changes the interest rates in 1997-2000.

YEAR (e1-e0 )/e0 - if

PURCHASING POWER PARITY: (e0 -e1)/e0 = ih - rf

=

ih

1997-2000 No relation holds

2001-2006 Negative relation exists. Increase in inflation rates in India lead to an appreciation of Rupee

2007-2010 No relation exists

NET RESULT PPP holds in the period of 2001-2006.

ih - if =(e1- e0 Positive relation exists. )/e0 Devaluation of the rupee and a revaluation of dollars increased India inflation rate. Net result Changes in exchange rate leads to changes in inflation rate between US and India.

Negative relation exists. Appreciation of the rupee leads to an increase in inflation rate in India.
Inflation rate increase in India leads to appreciation of Rupee and vice versa.

No relation exists.

Change in exchange rate has a positive impact in 1997-2000 and a negative impact in 2001-2006.

Changes in inflation rate in US do not lead to any change in Dollars and Yen and vice versa.

A high inflation in India than US in 2001-2006 depreciated the exchange rate but a change in exchange rate changed the inflation rate in 19972000.

25 | P a g e

FISHER EFFECT:
is inflation rate)

rh

r f = ih - if

( r is nominal interest rate, i

YEAR rh - rf = ih -if

1997 -2000 Positive relation holds. An increase in inflation rate in India will cause lower interest rates in US. Positive relation holds. An increase in interest rate in India will cause an increase in inflation rates in India than US.

2001- 2006 AN increase in inflation rate in India will cause an increase in interest rates in India and lower interest rates in US. An increase in interest rate in India will cause an increase in inflation rates in India and lower inflation rates in US. Interest rate changes are caused due to inflation differential and vice versa

2007-2010 AN increase in inflation rate in India will cause an increase in interest rates in India and lower interest rates in US. An increase in interest rate in India will cause an increase in inflation rates in India and lower inflation rates in US. Interest rate changes are caused due to inflation differential and vice versa

Net result Fisher effect holds in all the three periods

ih -if = rh - rf

Fisher effect holds in all the three periods

Net result Interest rate changes are caused due to inflation rate differential and vice versa.

A high inflation rate in INDIA was persistent in all the three periods than US which raised interest rates in India.

INTERPRETATION:
From 1997 to 2010, there has been an increase in inflation rate in India compared to US especially in 1997 -1999 and in 2008-2010 and in order to prevent the increase in inflation, it lead to a direct increase in interest rate in India and lowered interest rates in US (Fisher Effect). However from the PPP, it is found that a devaluation of the Rupee increased interest rates and inflation rates in India directly in 1997-2000. However in the post crisis period of 2001-2006 interest rate differentials between countries did not directly affect exchange rate change but appreciated the Rupee through the direct effect of a rise in inflation rate on exchange rate depreciation and in 2007-2010 inflation rise in India did not directly affect exchange rate change but appreciated the Rupee through the direct effect of rise in interest rate in India.

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FIGURE DEVELOPING- DEVELOPED COUNTRY: US BRAZIL 1997 TO 2

2010:US FOREIGN COUNTRY, BRAZIL: HOME COUNTRY)

YEAR

INTERNATIONAL FISHER EFFECT: (e0 -e1)/e0 = rh - rf

1997-2000
=

2001-2006

2007-2010

NET RESULT

Positive relation No relation holds. A rise in exists rh - rf Interest in Brazil leads to devaluation of the Real than US (increase in exchange rate) rh -rf =(e1 - A devaluation of No relation real leads to rise exists e0 )/e0 in interest rates than US. YEAR 1997-2000 2001-2006 (e1-e0 )/e0 = ih Positive Negative relation exists. significant -Net result if A rise in the Change in Increased impact. An interest interest rate inflation rate in inflation rate rise Brazil increases in between US in Brazil Brazil will lead exchange rate toand Brazil has depreciates the revaluation (depreciation of of no impact on the REAL. the Brazilian Real) between Real exchange rate Brazil and US differential. ih - if =(e1- e0 and vice versa. )/e0 No relation holds. No relation holds.

(e1- e0 )/e0

Negative relation holds. A rise in Interest in Brazil leads to appreciation of the Brazilian real compared to US No relation exists 2007-2010

IFE holds only in the crisis period of 19972000 and 2007-2010.

Negative significant An increase in impact. An

interest rate in inflation rate rise India leads to an in Brazil will lead appreciation of to the revaluation Real depreciating of the Brazilian exchange rate. Real

Exchange rate differential between US and Brazil impacted the interest NET RESULT rate holds in all the PPP differential only in 1997-2000. periods. Interest rate rise in Brazil appreciates the exchange rate in 1997-2000 but depreciates exchange rate in 2007-2010. Change in exchange rate has a negative impact in 2007-2010.

Negative relation exists. Appreciation of Real leads to increase in inflation rate in Brazil

Net result Increase in Inflation rate inflation rate POWER PARITY: increase in Brazil PURCHASING in Brazil leads to depreciates appreciation of the Brazilian Real, hence Real, hence deprecating the appreciating exchange rate. the exchange rate.

A change in A high inflation in inflation )/e0in ih - rf than US rate = Brazil (e0 -e1 Brazil appreciates depreciates the the Brazilian Real exchange rate in and vice versa. 2001-2010 g e 27 | P a but appreciates it in 1997-2010.

FISHER EFFECT:
is inflation rate)

rh

r f = ih - if

( r is nominal interest rate, i

YEAR rh - rf = ih -if

1997 -2000 Positive relation holds. An increase in inflation rate in Brazil will cause lower interest rates in US.

2001- 2006 AN increase in inflation rate in Brazil will cause an increase in interest rates in Brazil and lower interest rates in US. An increase in interest rate in Brazil will cause an increase in inflation rates in Brazil and lower inflation rates in US. Interest rate changes are caused due to inflation differential and vice versa

2007-2010 AN increase in inflation rate in Brazil will cause an increase in interest rates in Brazil and lower interest rates in US. An increase in interest rate in Brazil will cause an increase in inflation rates in Brazil and lower inflation rates in US. Interest rate changes are caused due to inflation differential and vice versa

Net result Fisher effect holds in all the three periods

ih -if = rh - rf

Positive relation holds. An increase in interest rate in Brazil will cause an increase in inflation rates in Brazil than US. Net result Interest rate changes are caused due to inflation rate differential and vice versa.

Fisher effect holds in all the three periods

A high inflation rate in Brazil was persistent in all the three periods than US which raised interest rates in Brazil.

INTERPRETATION:
From 1997 to 2010, there has been an increase in inflation rate in Brazil compared to US especially in the post crisis period of 2001-2005 and in order to prevent the increase in inflation, it lead to a direct increase in interest rate in Brazil and lowered interest rates in US (Fisher Effect). However from PPP and IFE, it is found that increased interest rates and inflation rates in Brazil directly increased exchange rate in 1997-2000. However in the post crisis period of 2001-2006 interest rate differentials between countries did not directly affect exchange rate but appreciated the Real through the direct effect of a rise in inflation rate on exchange rate depreciation and in 2007-2010 both the inflation rise and interest rate rise in Brazil directly depreciated the exchange rate due to the appreciation of the Real.

28 | P a g e

FIGURE

DEVELOPING-

FIGURE DEVELOPED 3

COUNTRY:

JAPANBRAZIL

(BRAZIL: HOME COUNTRY) 1997 -2010

INTERNATIONAL FISHER EFFECT : (e0 -e1)/e0 = rh - rf

1997-2000 No relation exists 2001-2006 No relation exists 2007-2010 No relation exists NET RESULT IFE does not hold in any period.

YEAR (e1- e0 )/e0

rh - rf rh -rf =(e1

e0 )/e0 Net result

- No relation exists. A rise in the interest rate in Brazil does not change exchange rate in JAPAN.

No relation exists Change in interest rate between Japan and Brazil has no impact on exchange rate differential. rh rf = ih - if

No relation exists An increase in interest rate in India leads to an appreciation of Real depreciating exchange rate.

IFE does not hold in any period. Interest rate rise in Brazil does not affect the exchange rate between Japan and Brazil in any of the periods.

FISHER EFFECT:
inflation rate)

( r is nominal interest rate, i is

29 | P a g e

YEAR rh - rf = ih -if

1997 -2000 Positive relation holds. An increase in inflation rate in Brazil will cause lower interest rates in Japan.

2001- 2006 AN increase in inflation rate in Brazil will cause an increase in interest rates in Brazil and lower interest rates in Japan. An increase in interest rate in Brazil will cause an increase in inflation rates in Brazil and lower inflation rates in Japan. Interest rate changes are caused due to inflation differential and vice versa

2007-2010 AN increase in inflation rate in Brazil will cause an increase in interest rates in Brazil and lower interest rates in Japan. An increase in interest rate in Brazil will cause an increase in inflation rates in Brazil and lower inflation rates in Japan. Interest rate changes are caused due to inflation differential and vice versa

Net result Fisher effect holds in all the three periods

ih -if = rh - rf

Positive relation holds. An increase in interest rate in Brazil will cause an increase in inflation rates in Brazil than Japan. Net result Interest rate changes are caused due to inflation rate differential and vice versa.

Fisher effect holds in all the three periods

A high inflation rate in Brazil was persistent in all the three periods than Japan which raised interest rates in Brazil.

PURCHASING POWER PARITY: (e0 -e1)/e0 = ih - rf

1997-2000 No relation exists 2001-2006 No relation exists 2007-2010 No relation exists NET RESULT PPP does not hold in any period.

YEAR (e1- e0 )/e0

rh - rf rh -rf =(e1

e0 )/e0 Net result

- No relation exists. A rise in the inflation rate in Brazil does not change exchange rate in JAPAN.

No relation exists Change in inflation rate between Japan and Brazil has no impact on exchange rate differential.

No relation exists An increase in inflation rate in Brazil has no impact on exchange rate differential.

ppp does not hold in any period. Inflation rate rise in Brazil does not affect the exchange rate between Japan and Brazil in any of the periods.

INTERPRETATION:
30 | P a g e

From 1997 to 2010, there has been an increase in inflation rate in Brazil compared to Japan and in order to prevent the increase in inflation, it lead to a direct increase in interest rate in Brazil and lowered interest rates in Japan (Fisher Effect). However from PPP and IFE, it is found that increased interest rates and inflation rates in Brazil does not directly or indirectly affect the devaluation or revaluation of the exchange rate between the Brazil and Japan as shown in the figure below that interest rate and inflation was constantly high in Brazil than Japan but exchange rate fluctuated through out the entire period.

FIGURE 4

DEVELOPING-

DEVELOPED

COUNTRY:

JAPAN

INDIA(INDIA: HOME COUNTRY) 1997 -2010

INTERNATIONAL FISHER EFFECT : (e0 -e1)/e0 = rh - rf

FIGURE

31 | P a g e

YEAR (e1- e0 )/e0

rh - rf rh -rf =(e1

1997-2000 No relation exists

2001-2006 No relation exists

2007-2010 No relation exists

NET RESULT IFE does not hold in any period.

e0 )/e0 Net result

- No relation exists. A rise in the interest rate in India does not change exchange rate in JAPAN.

No relation exists Change in interest rate between Japan and India has no impact on exchange rate differential.

No relation exists An increase in interest rate in India leads to an appreciation of Rupee depreciating exchange rate.

IFE does not hold in any period. Interest rate rise in India does not affect the exchange rate between Japan and India in any of the periods.

FISHER EFFECT:
inflation rate) 1997 -2000 Positive relation holds. An increase in inflation rate in India will cause lower interest rates in Japan.

rh

rf = ih - if

( r is nominal interest rate, i is

YEAR rh - rf = ih -if

2001- 2006 AN increase in inflation rate in India will cause an increase in interest rates in India and lower interest rates in Japan. An increase in interest rate in India will cause an increase in inflation rates in India and lower inflation rates in Japan. Interest rate changes are caused due to inflation differential and vice versa

2007-2010 AN increase in inflation rate in India will cause an increase in interest rates in Brazil and lower interest rates in Japan. An increase in interest rate in India will cause an increase in inflation rates in India and lower inflation rates in Japan. Interest rate changes are caused due to inflation differential and vice versa

Net result Fisher effect holds in all the three periods

ih -if = rh - rf

Positive relation holds. An increase in interest rate in India will cause an increase in inflation rates in India than Japan. Net result Interest rate changes are caused due to inflation rate differential and vice versa.

Fisher effect holds in all the three periods

A high inflation rate in India was persistent in all the three periods than Japan which raised interest rates in India.

32 | P a g e

PURCHASING POWER PARITY: (e0 -e1)/e0 = ih - rf

1997-2000 A rise in inflation rate in India led to the depreciation of the Rupee, increasing exchange rate. No relation exists. 2001-2006 No relation exists 2007-2010 No relation exists NET RESULT Only in 1997-2000, an increase in inflation rate in India increases the exchange rate.

YEAR (e1- e0 )/e0

rh - rf

rh -rf e0 )/e0

=(e1

No relation exists Change in inflation rate between Japan and India has no impact on exchange rate differential.

Net result

A rise in the inflation rate in India increases the exchange rate between India and Japan.

No relation exists Change in inflation rate between Japan and India has no impact on exchange rate differential.

PPP does not hold in any period. Inflation rate rise in India affects the exchange rate between Japan and India only in 19972000.

INTERPRETATION:
From 1997 to 2010, there has been an increase in inflation rate in India compared to Japan and in order to prevent the increase in inflation, it lead to a direct increase in interest rate in India and lowered interest rates in Japan (Fisher Effect). However from PPP and IFE, it is found that increased interest rates and inflation rates in India does not directly or indirectly affect the devaluation or revaluation of the exchange rate between the India and Japan in from 2001-2010. However PPP did hold in the period of 1997-2000. As shown in the figure below that interest rate and inflation was constantly high in India than Japan but exchange rate fluctuated through out the entire period.

33 | P a g e

DEVELOPING-

FIGURE DEVELOPING COUNTRY:

INDIA-BRAZIL

(INDIA: HOME COUNTRY) 1997 -2010

INTERNATIONAL FISHER EFFECT: (e0 -e1)/e0 = rh - rf

34 | P a g e

FISHER EFFECT:
inflation rate)

rh

r f = ih - if

( r is nominal interest rate, i is

YEAR rh - rf = ih -if

1997 -2000 Negative relation holds. An increase in inflation rate in India lowered interest rates in India.

2001- 2006 Positive relation holds. AN increase in inflation rate in Brazil will cause an increase in interest rates in Brazil and lower interest rates in India. An increase in interest rate in Brazil will cause an increase in inflation rates in Brazil and lower inflation rates in India. Interest rate changes are caused due to inflation differential and vice versa

2007-2010 Negative relation holds. An increase in inflation rate in India lowered interest rates in India. Negative relation holds. A decrease in interest rate in India will cause an increase in inflation rates in India thanBrazil. Interest rate changes are caused due to inflation differential and vice versa

Net result Fisher effect holds in all the three periods

ih -if = rh - rf

Negative relation holds. A decrease in interest rate in India will cause an increase in inflation rates in India than Brazil. Net result Interest rate changes are caused due to inflation rate differential and vice versa.

Fisher effect holds in all the three periods

Inflation was India in the two crisis period which lowered interest in India and was high in Brazil in 2001-2006 due to high inflation in Brazil.

PURCHASING POWER PARITY: (e0 -e1)/e0 = ih - rf

1997-2000 A rise in inflation rate in India led to the appreciation of the Rupee, decreasing exchange rate. No relation exists. 2001-2006 No relation exists 2007-2010 No relation exists NET RESULT Only in 1997-2000, an increase in inflation rate in India decreased the exchange rate.

YEAR (e1- e0 )/e0

rh - rf

rh -rf e0 )/e0

=(e1

No relation exists Change in inflation rate between Japan and India has no impact on exchange rate differential.

Net result

A rise in the inflation rate in India decreased the exchange rate between India and Japan.

No relation exists Change in inflation rate between Japan and India has no impact on exchange rate differential.

PPP does not hold in any period. Inflation rate rise in India affects the exchange rate between Japan and India only in 19972000.

INTERPRETATION:
35 | P a g e

From 1997 to 2000 and 2007-2010, there was an increase in inflation rate in India compared to Brazil but due to the negative relation between interest rate and inflation rates, interest rates fell in India. However from 2001-2006 inflation rates were lower in India which kept interest rates low as well. In 1997-2010 a high inflation rate and a low interest rate in India directly appreciated the Rupee through PPP and IFE respectively. In 20012006 the low inflation rate indirectly and a low interest rate directly appreciated the Rupee in India and it is found that in 2007-2010 increased inflation rates and lower interest rates in India indirectly and directly depreciated the rupee hence increasing exchange rate.

FIGURE

SUMMING UP:
COUNTRIE S
DevelopedDeveloped US -JAPAN Developed Developing

YEAR 19972000
IFE: Significant Negative Effect FE :Positive Effect PPP: No effect
IFE: Positive effect FE: Positive Effect

2001 -2006
IFE: Significant Negative Effect FE :Positive Effect PPP: Positive effect IFE: No effect FE :Positive Effect

2007 -2010
IFE: Significant positive Effect FE :Positive Effect PPP: No effect IFE: Significant negative Effect FE :Positive Effect
36 | P a g e

US - INDIA Developed Developing US - BRAZIL Developed Developing JAPAN -BRAZIL Developed Developing JAPANINDIA DevelopingDeveloping INDIA -BRAZIL

PPP: Positive Effect IFE: Positive effect FE: Positive Effect PPP: Positive Effect

PPP: Negative effect IFE: No effect FE :Positive Effect PPP: Negative effect

PPP: No effect IFE: Significant negative Effect FE :Positive Effect PPP: Negative effect IFE: No effect FE : Positive effect PPP : No effect

IFE: No effect IFE: No effect FE: Positive FE : Positive effect Effect PPP : No effect PPP : No effect IFE: No effect IFE: No effect FE : Positive FE : Positive effect Effect PPP : No effect PPP : Positive Effect
IFE: Positive effect FE: Negative Effect PPP: Negative Effect IFE: Positive effect FE: Positive Effect PPP: No Effect

IFE: No effect FE : POSITIVE EFFECT PPP : No effect

IFE: Negative effect FE: Negative Effect PPP: NO Effect

IX.

CONCLUSION

Among all the four countries, the developing countries of India and Brazil had high inflation rates compared to developed countries of Japan and US. Japan maintained a low inflation rate and low interest rates compared to the others and had no direct and indirect impact of a change in inflation rate and interest rate on exchange rate fluctuations between Japan and
37 | P a g e

the developing countries in the crisis and the post crisis periods, indicating insignificant trade relations. There existed a positive relation between interest rate changes and inflation rate changes, that is Fisher effect was significant for all the developed and developing countries in the three periods except for India and Brazil where there existed a negative significant relationship. Trade relations were strong between US and the other countries. US had a high inflation and a high interest rate compared to Japan in all the three periods but there was an appreciation in exchange rate in 1997-2000 and depreciation in exchange rate in 20072010 between US and Japan, caused due to the direct effect of change in interest rates and indirect effect of inflation rate differential. This showed that United States had an increase in money supply and imported products more from Japan, so funds flew from US to JAPAN. However interest rates and inflation rates were high in India and Brazil when compared to US. India had a high inflation than US which implied a rise in money supply, hence Government increased interest rates to control money supply and exports fell which depreciated the Rupee in 1997 -2006. However in 2007-2010, inflation rate was high in US due to the economic crisis which decreased the exchange between US and India and increased exports in India to some extent. The similar incidents took place between Brazil and US. Hence in this project, we come to the conclusion that Fisher effect held between developing and developed countries in all the crisis period. However International Fisher Effect and Purchasing Power Parity did not hold for Japan and Brazil and Japan and India in any of the periods. IFE had a significant negative effect for US and Japan in all the three periods but PPP had no effect in the two crisis period but had a positive effect in the post crisis period for US and Japan. For both India and Brazil in relation with US, IFE had a positive effect in 1997-2000, no effect in 2001-2006 and a negative effect in 2007-2010 due to the economic crisis, whereas PPP had a positive effect in 1997-2000, negative effect in 2001-2006 and no effect in the economic crisis. So exchange rate fluctuations were directly affected by interest rates changes in India and Brazil compared to
38 | P a g e

US and indirectly by Inflation rate changes in the period 2007-2010. However India and Brazil are very strongly related in terms of trade and economic development. Inflation rate was high in India during the crisis periods and were low in the post crisis period but interest rates in India remained low in 1997-2000 and 2007-2010 due to the negative relation between interest rate and inflation rate and low in 2001-2006 due to the positive Fisher effect. So the exchange rate depreciated from 1997-2006 and appreciated from 2007-2010 due to the direct effect of interest rate changes between them, hence increasing exports in India from 1997-2006 and decreasing exports in the economic crisis.

39 | P a g e

REFERENCES
1. Mishkin, F. S and J. Simon, 1995. An Empirical Examination of the

Fisher Effect in Australia, NBER Working Paper No.5080, NBER, MA.

2. Levich, Richard M. Empirical Studies of Exchange Rates: Price

Behavior, Rate Determination and Market Efficiency. In Handbook of International Economics, Vol. 2. Ronald W. Jones and Peter B. Kenen, eds. Netherlands: Elsevier B.V., 1985.
3.

Utami, Siti Rahmi. Exchange Rates, Interest Rates, and Inflation Rates in Indonesia: The International Fisher Effect Theory. International Research Journal of Finance and Economics ISSN 1450-2887 Issue 26 (2009) Euro Journals Publishing, Inc. 2009
http://www.eurojournals.com/finance.htm.

4. Mughal, Hammad Ul Haq and Kamal, Yasir (Shaheed Zulfikar Ali Bhutto

Institute of Science and Technology, Islamabad) Modeling the Exchange Rate Volatility Using GARCH-M Type Models: Evidence From Pakistan. June 25th, 2009.
5. Duarte, Antnio Portugal, Faculty of Economics, University of Coimbra

and Group for Monetary and Financial Studies, Purchasing power parity: An Empirical Study of Three EMU countries.

BOOKS:
Multinational Finance Management by Alan C. Shapiro, University of Southern California. International Finance by Maurice D. Levi.

WEBSITES:
www.oecd.org www.oanda.com

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