Question

The international Fisher effect theory (IFE) says that interest rate differences between two completely different countries will be offset equally by opposite changes in _________.

A. The American Dollar

B.Euro

C. Future spot rate

D. Future interest rate

Answer 1

The international Fisher effect theory (IFE) says that interest rate differences between two completely different countries will be offset equally by opposite changes in :-

C) Future Spot rate

Explanation :-

The International Fisher Effect is an extension of Fisher effect. The Fisher effect named after US economist Irving Fisher, shows the impact of inflation on nominal interest rate. The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.
The Fisher Effect can be seen from the bank savings rate; the interest rate an investor has on a savings account is really the nominal interest rate. For example, if the nominal interest rate on a savings account is 4% and the expected rate of inflation is 3%, then the money in the savings account is really growing at 1%. The smaller the real interest rate, the longer it will take for savings deposits to grow substantially when observed from a purchasing power perspective.
The International Fisher expands on the Fisher Effect theory by suggesting that the estimated appreciation or depreciation of two countries’ currencies is proportional to the difference in their nominal interest rates. For example, if the nominal interest rate in the United States is greater than that of the United Kingdom, the former’s currency value should fall by the interest rate differential. It is used to predict and understand present and future spot currency price movements.

The International Fisher effect is derived by combining the Fisher effect with relative Purchasing Power Parity.
Fisher effect links inflation and interest rates while PPP says that exchange rates move to offset change in the inflation differentials.

The International Fisher Effect (IFE) states that the difference between the nominal interest rates in two countries is directly proportional to the changes in the exchange rate of their currencies at any given time.The International Fisher Effect theory was recognized on the basis that interest rates are independent of other monetary variables and that they provide a strong indication of how the currency of a specific country is performing.

The theory assumes that a country with lower interest rates will see lower levels of inflation, which will translate to an increase in the real value of the country’s currency in comparison to another country’s currency. When interest rates are high, there will be higher levels of inflation, which will result in the depreciation of the country’s currency.

The International Fisher effect can be written as:-

The key meaning of the above formulae is that the spot exchange rate should change equally but opposite to any interest rate differentials between two economies (assuming that the differentials are the reflection of inflation diffrentials). Thus any currency with high nominal interest rate (as a result of high inflation rate) would be expected to depreciate in the future. Hence using IFE, businesses would be able to predict exchange rate movements in the future by comparing the relative interest rates in any two countries.

For example, let us 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.
As per IFE, the country with the higher nominal interest rate (Great Britain in this case) will see its currency depreciate.
From the aforesaid formulae of the IFE, the expected future spot rate is calculated by multiplying the spot rate by a ratio of the foreign interest rate to the 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).