Understanding the Impact of Interest Rates on Exchange Rates
The International Fisher Effect (IFE) is an intriguing economic theory that ties the expected changes in the exchange rates of two currencies to the difference between their respective nominal interest rates.
Key Insights
- The International Fisher Effect (IFE) suggests that variations in nominal interest rates between countries can forecast exchange rate changes.
- According to IFE, countries with higher nominal interest rates tend to witness higher inflation rates, leading to currency depreciation against nations with lower interest rates.
- In practice, IFE’s evidence is mixed, and more direct estimation of currency exchange movements from expected inflation is common recently.
Exploring the Core of the International Fisher Effect (IFE)
The theory is centered on analyzing interest rates related to risk-free investments, like Treasuries, helping to predict currency movements. Unlike methods focusing solely on inflation rates, IFE combines views of inflation and interest rates to estimate currency appreciation or depreciation.
The IFE is founded on the premise that real interest rates remain stable, independent of monetary variables like monetary policies. Real interest rates give insights into a currency’s health in the global market. IFE suggests that countries with lower interest rates also have lower inflation rates, potentially increasing the real value of their currency. Conversely, higher interest rates can lead to currency depreciation.
This essential theory was introduced by U.S. economist Irving Fisher.
Calculating the International Fisher Effect
The IFE formula is:
Where:
- E = The percent change in the exchange rate
- i1 = Country A’s interest rate
- i2 = Country B’s interest rate
Example: If Country A’s interest rate is 10% and Country B’s interest rate is 5%, then Country B’s currency should appreciate by roughly 5% compared to Country A’s currency. The reasoning is that higher interest rates align with higher inflation, causing currency depreciation in countries with higher interest rates compared to ones with lower rates.
Differentiating the Fisher Effect and the International Fisher Effect
Although related, the Fisher Effect and IFE are distinct concepts. The Fisher Effect states that nominal interest rates represent the real rate of return plus anticipated inflation. IFE builds upon this by asserting that nominal interest rates reflect expected inflation rates, making currency changes proportional to the differences in nominal interest rates between two countries.
Applying the International Fisher Effect in Real-World Scenarios
Empirical studies on IFE offer mixed results, suggesting that additional factors influence currency exchange rate movements. Historically, when interest rates underwent more significant adjustments, IFE’s validity was stronger. Recently, with low global inflation expectations and interest rate alterations, other measures like consumer price indexes (CPI) are often employed to estimate currency exchange rate changes.
Related Terms: Fisher Effect, inflation, interest rates, exchange rates, currency depreciation, nominal interest rates.
References
- Peter Moles and Nicholas Terry. “Handbook of International Financial Terms”, Page 298. Oxford University Press, 1997.
- Hatemi-J, Abdulnasser. “The International Fisher Effect: Theory and Application”. Investment Management and Financial Innovations, vol. 6, no. 1, January 2009, pp. 117-121.
- The Library of Economics and Liberty. “Irving Fisher, 1867-1947”.
- Rahnema, Ahmad. “An Overview of Exchange and Interest Rate Risk Management (How to Make Risk Management Strategy A Competitive Weapon)”. IESE Business School, University of Navarra, Working Paper WP-178, February, 1990, pp. 2.
- Peter Moles and Nicholas Terry. “Handbook of International Financial Terms”, Pages 223, 298. Oxford University Press, 1997.
