Question

Define fisher effect and explain three reasons why it is also applied to international markets.

Answer 1

The fisher effect is the theory which explains the relationship between the real interest rate and nominal interest rate. It says that the real interest rate equals to the nominal interest rate minus the inflation rate. This economic theory has also been applied to the international market in currency appreciation and depreciation and exchange rate movement.

The reasons why this is also applied to international market is

· It helps in the forecasting the movement of exchange rate. Currencies with high interest rate are expected to depreciate while currencies with low interest rates are expected to appreciate.

· It helps in separation of real return expected from an investment from a nominal return being generated by the asset.

· It also helps the investors in breaking down the return in international market by decomposing the return into return from asset and return from appreciation or depreciation of currency.