The
International Fisher effect is a hypothesis in
international financeInternational finance is the branch of economics that studies the dynamics of exchange rates, foreign investment, global financial system, and how these affect international trade. It also studies international projects, international investments and capital flows, and trade deficits. It includes...
that says that the difference in the
nominal interest rateIn finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...
s between two countries determines the movement of the nominal exchange rate between their
currenciesIn economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
, with the value of the currency of the country with the lower nominal interest rate increasing. This is also known as the assumption of Uncovered Interest Parity.
Motivation
The
Fisher hypothesisIn economics, the Fisher hypothesis is the proposition by Irving Fisher that the real interest rate is independent of monetary measures, especially the nominal interest rate. The Fisher equation isr_r = r_n - \pi^e....
says that the real
interest rateAn interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
in an economy is independent of
monetaryMoney is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
variables. If we add to this the assumption that real interest rates are equated across countries, then the country with the lower
nominal interest rateIn finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...
would also have a lower rate of
inflationIn economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
and hence the real value of its currency would be risen over time.
Capital Market Integration
The generalized Fisher effect holds that real interest rates must be the same across borders. However, validity of the generalized Fisher effect requires
capital marketA capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...
integration.
In order for the generalized Fisher theorem to hold, capital markets must be integrated. That is, capital must be allowed to flow freely across borders. In general, the capital markets of
developed countriesA developed country is a country that has a high level of development according to some criteria. Which criteria, and which countries are classified as being developed, is a contentious issue...
are integrated. However, in many less developed countries, we can observe currency restrictions and other regulation that inhibit integration.
Example
Suppose that the current
spot exchange rateThe spot price or spot rate of a commodity, a security or a currency is the price that is quoted for immediate settlement . Spot settlement is normally one or two business days from trade date...
for U.S. Dollars into British Pounds is $1.4339 per pound. If the current interest rate is 5 percent in the U.S. and 7 percent in Britain, what is the expected spot exchange per pound rate 12 months from now according to the International Fisher Effect?
The International Fisher Effect estimates future exchange rates based on the relationship in nominal interest rates. Multiplying the current spot exchange rate by the nominal annual U.S. interest rate and dividing by the
(norminal interest rate will affect inflation and domestic price levels)Italic textannual British interest rate yields the estimate of the spot exchange rate 12 months from now ($1.4339 * 1.05) / 1.07 = $1.4071.