What Is the International Fisher Effect?

The International Fisher Effect (IFE) is an economic theory that posits the expected difference between two currencies’ exchange rates is generally equivalent to the variation in their respective countries’ nominal interest rates.

### Key Points to Note:

• The IFE suggests that disparities in nominal interest rates among nations can serve as indicators for predicting shifts in exchange rates.
• According to the IFE, countries with higher nominal interest rates typically face elevated inflation rates, leading to depreciation of their currency relative to others.
• In practice, the IFE’s applicability has shown mixed results, with recent trends indicating a shift towards estimating currency movements through expected inflation rates.

Understanding the International Fisher Effect (IFE)

The IFE is rooted in examining present and future risk-free investment interest rates, like Treasuries, to aid in forecasting currency fluctuations. It combines inflation and interest rate insights to gauge a currency’s appreciation or depreciation, distinguishing it from approaches reliant solely on inflation metrics.

Central to the theory is the belief that real interest rates stand apart from other monetary factors, providing a stronger indication of a currency’s performance in the global market. Lower interest rates in a country are linked to lower inflation levels, potentially boosting that currency’s real value compared to nations with higher interest rates, which are prone to currency devaluation.

The IFE’s namesake is the renowned U.S. economist Irving Fisher, underlining the reputable origins of this theory.

Calculating the International Fisher Effect

The IFE formula:

E = i1 – i2 1 + i2 ≈ i1 – i2 where: E = percentage change in the exchange rate i1 = interest rate in Country A i2 = interest rate in Country B

For instance, if Country A’s rate is 10% and Country B’s is 5%, Country B’s currency is expected to appreciate by about 5% against Country A’s. The rationale behind IFE is that higher interest rates in a country are typically linked to higher inflation rates, resulting in currency depreciation against those with lower interest rates.

The Fisher Effect and the International Fisher Effect

Though related, the Fisher Effect and IFE are distinct models. The Fisher Effect contends that nominal interest rates encompass expected inflation and real returns. On the other hand, IFE expands on this by suggesting that currency rate changes are influenced by the disparity in nominal interest rates between two countries, given that nominal rates reflect predicted inflation rates.

Application of the International Fisher Effect

Empirical studies evaluating IFE have yielded varied outcomes, likely due to other factors impacting currency exchange rate shifts. While the IFE historically held more sway during periods of substantial interest rate adjustments, recent times of low inflation expectations and nominal rates globally have seen a shift towards utilizing direct inflation predictions, like Consumer Price Index (CPI), for estimating currency rate changes.