Discussion Board Post: What’s the Implication of the IFE for forecasting exchange rates?

Discussion Board Post:

What’s the Implication of the IFE for forecasting exchange rates?

Expert Solution

For example, suppose the GBP/USD spot exchange rate is 1.5339 and the current interest rate is 5% in the U.S. and 7% in Great Britain. The IFE predicts the country with the higher nominal interest rate (Great Britain in this case) will see its currency depreciate. The expected future spot rate is calculated by multiplying the spot rate by a ratio of the foreign interest rate to domestic interest rate: 1.5339 x (1.05/1.07) = 1.5052. The IFE expects the GBP to depreciate against USD (it will only cost $1.5052 to purchase one GBP compared to $1.5339 before) so investors in either currency will achieve the same average return (i.e. an investor in USD will earn a lower interest rate of 5% but will also gain from appreciation of the USD).

For the shorter term, the IFE is generally unreliable due to the numerous short-term factors that affect exchange rates and predictions of nominal rates and inflation. Longer-term International Fisher Effects have proven a bit better, but not by much. Exchange rates eventually offset interest rate differentials, but prediction errors often occur. Remember that we are trying to predict the spot rate in the future. IFE fails particularly when purchasing power parity fails. This is defined as when the cost of goods can't be exchanged in each nation on a one-for-one basis after adjusting for exchange-rate changes and inflation.

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jeff jeffy answered 1 year ago

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