The International Fisher Effect: How Inflation Expectations Drive Exchange Rates

1. Introduction:

In order to understand the International Fisher Effect, one first needs to understand the relationship between nominal rates of interest and inflation rates. This relationship is often referred to as the “Fisher Effect”. The Fisher Effect states that the nominal rate of interest is equal to the real rate of interest plus the expected inflation rate. In other words, when inflation is expected to increase, the nominal interest rate will also increase in order to maintain the same real interest rate.

The International Fisher Effect (IFE) extends this concept to two different countries. It states that the difference between the nominal interest rates in two countries is equal to the difference between their expected inflation rates. Therefore, if Country A has a higher interest rate than Country B, it is because inflation is expected to be higher in Country A than in Country B.

The IFE can be used to predict exchange rates between two countries. If Country A has a higher nominal interest rate than Country B, then the currency of Country A will appreciate against the currency of Country B. This is because investors will be looking to invest their money in Country A in order to earn a higher return. As demand for the currency of Country A increases, its value will increase relative to the currency of Country B.

3. How can the International Fisher Effect be used to predict exchange rates?

As we have seen, the IFE states that the difference between the nominal interest rates in two countries is equal to the difference between their expected inflation rates. Therefore, if we know the current interest rates and inflation rates in both Country A and Country B, we can use this information to predict how their exchange rate will change in the future.

Let’s say that currently, Country A has a higher nominal interest rate than Country B by 2%. This means that inflation is expected to be higher in Country A than in Country B by 2%. If nothing changes, we would expect that over time, the value of Country A’s currency will appreciate against Country B’s currency by 2%.

Now let’s say that there is a sudden change in expectations and investors now believe that inflation will be higher in Country B than in Country A. This would cause a shift in investment from Country A toCountry B and lead to a depreciation of Country A’s currency againstCountry B’s currency.

4. Conclusion:

The International Fisher Effect is a powerful tool that can be used to predict how exchange rates will move over time. By understanding how it works, investors can make more informed decisions about where to invest their money.

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