What Is International Fisher Effect?

An in-depth exploration of the International Fisher Effect (IFE), including its definition, practical examples, and mathematical formula, to understand the relationship between interest rates and exchange rates.

The International Fisher Effect (IFE) posits that the expected change in the exchange rate between two currencies over time will be approximately proportional to the difference in their nominal interest rates. This theory is an extension of the Fisher Effect, which describes the relationship between nominal interest rates, real interest rates, and inflation within a single country.

Mathematical Representation

The formula representing the International Fisher Effect can be expressed as:

$$ E \left( \frac{S_{t+1}}{S_t} \right) = \frac{1 + i_d}{1 + i_f} $$

where:

• \(E ( \frac{S_{t+1}}{S_t} )\) is the expected exchange rate change.
• \(i_d\) is the domestic nominal interest rate.
• \(i_f\) is the foreign nominal interest rate.

Rearranging for the expected future exchange rate \( S_{t+1} \), the formula becomes:

$$ E(S_{t+1}) = S_t \times \left( \frac{1 + i_d}{1 + i_f} \right) $$

Practical Example

Assume the following:

• The domestic nominal interest rate (\(i_d\)) is 5%.
• The foreign nominal interest rate (\(i_f\)) is 3%.
• The current exchange rate (\(S_t\)) is 1.2 USD/EUR.

According to the IFE, in one year, the exchange rate should adjust to:

$$ E(S_{t+1}) = 1.2 \times \left( \frac{1 + 0.05}{1 + 0.03} \right) = 1.2 \times \left( \frac{1.05}{1.03} \right) \approx 1.224 USD/EUR $$

Historical Context and Applicability

The International Fisher Effect is named after the American economist Irving Fisher who made significant contributions to understanding interest rates and inflation. While the IFE offers insights into the long-term movements of exchange rates, it is important to note that in the short-term, exchange rates are also influenced by numerous other factors including investor sentiment, market speculation, political events, and macroeconomic data.

Comparisons and Related Terms

Fisher Effect: Within a single country, this effect explains the relationship between nominal interest rates, real interest rates, and inflation.

Purchasing Power Parity (PPP): This concept states that in the long term, exchange rates should move towards the rate that equalizes the price of an identical basket of goods in two different countries.

Interest Rate Parity (IRP): This theory asserts that the difference in interest rates between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

FAQs

What is the primary implication of the International Fisher Effect?

The primary implication of the IFE is that countries with higher nominal interest rates will see their currencies depreciate relative to those of countries with lower nominal interest rates.

How reliable is the International Fisher Effect for predicting exchange rates?

While the IFE provides a theoretical framework, actual exchange rate movements are influenced by many factors beyond interest rate differentials, and thus the IFE may not always accurately predict short-term changes.

How is the International Fisher Effect related to the Fisher Effect?

The International Fisher Effect extends the Fisher Effect, which deals with the relationship between nominal interest rates, real interest rates, and inflation in a single country, to the international context by comparing two countries.

References

1. Fisher, Irving. The Theory of Interest. Macmillan, 1930.
2. Paul R. Krugman, Maurice Obstfeld, and Marc J. Melitz. International Economics: Theory and Policy, 10th edition. Pearson, 2014.

Summary

The International Fisher Effect provides a useful theoretical framework for understanding the relationship between interest rate differentials and exchange rate movements. While impactful for long-term financial and economic analysis, its application as a predictive tool for short-term currency fluctuations should be tempered with an understanding of other influencing factors.