INTERNATIONAL

FISHER’S
EFFECT

PRESENTED BY:
RAVI
RITHIKA
 INTRODUCTION:
The Fisher's Effect is an economic theory proposed by
economist Irving Fisher in the year 1930. The Fisher's
Effect describes the relationship between inflation and
both real and nominal interest rates. It is based on pre
sent and future risk- free nominal interest rates rather
than pure inflation, and it is used to predict and under
stand present and future and currency price movemen
ts.
FISHER'S EFFECT:

The Fisher's Effect states that whenever an investor

thinks of an investment, he is interested in a particul
ar nominal interest rate which covers both the expec
ted inflation and the required real interest rate.
Mathematically, it can be expressed as:

1 + r = ( 1 + a )( 1 + I)

Where, r= nominal interest rate,

a= real interest rate,

I= expected rate of inflation.

Suppose the required real interest rate is 4℅ and e

xpected rate of inflation is 10℅, the required nomi
nal interest rate will be:

1.0 4 × 1.10 - 1 = 14.4℅

 INTERNATIONAL FISHER'S EFFECT:
The IFE states that an expected change in the current ex
change rate between any two currencies is approximately e
quivalent to the difference between the two countries' nom
inal interest rate for that time. It can be written as:

(1+rA/ 1+rB)= (1+IA/ 1+IB)

The IFE is a hypothesis in international finance that s

uggests differences in nominal rates reflect expected chang
es in the spot exchange rate between countries.
 The hypothesis specially states that a spot exchange r
ate is expected to change equally in the opposite directio
n of the interest rate differential.

Thus, the currency of the country with higher nominal

interest rate is expected to depreciate against the curren
cy of the country with the lower nominal interest rate ,a
higher nominal interest rates reflect an expectation of in
flation.
 ASSUMPTION OF THE IFE:

1. On an international level, the Fisher's model assu

mes that the real rate requirement is similar across
major industrial countries.

2. Any observed market interest rate differences be

tween countries according to this model is accounte
d for on the basis of differences in inflation expecta
tions.
3. Changes in spot exchange rates are related to diff
erences in market interest rates between countries.

4. Currencies of high interest rate countries will wea

ken. Because these countries have high inflationary
expectations.

5. Currencies of low interest rate countries will stre

ngthen. Because these countries have low expectati
ons.
 PRACTICAL USE OF IFE:
a. Neither model appears appropriate for short term fore
casting( less than one year).

b. Work better for the long term and in this regard appea
r to be good indicators of the long trend in the exchange
rate:

• Relatively high (low), inflation currencies will exhibit lo

ng term depreciation (appreciation).

• Relatively high (low), interest rate currencies will exhib

it long term depreciation (appreciation).
PROBLEMATIC ISSUES REGARDING TH
E IFE:
a. User relies in market interest rate data to proxy for
future inflation.

b. However are real rates similar across countries.

c. Do real rates change over time.

d. Inflationary expectations during the forecasted hori

zon are subject to change.
 WHY THE IFE DOESN'T OCCUR?
 Since the IFE is based on PPP it will not hold when
PPP doesn't hold.
 In particular, if there is factors other than inflatio
n that effect exchange rates, exchange rates may
not adjust in accordance with the inflation differe
ntial.
Theory Key variables of theory Summary of theory

Interest Forward rate Interest The forward rate of one

Rate Parity premium (or differentia currency with respect to
(IRP) discount) l
another will contain a
premium ( or discount)
that is determined by the
differential in interest
rates between the two
countries.

Purchasing Percentage Inflation The spot rate of one

Power change in spot rate currency with respect to
Parity exchange rate differentia
(PPP) l
another will change in
relation to the differential
in inflation rates between
the two countries
International Percentage Interest The spot rate of
Fisher’s change in rate one currency with
Effect
( IFE)
spot differenti respect to another
exchange al will change in
rate accordance with
the differential in
interest rates
between the two
countries.
Conclusion:

International Fishers effect based on

expected changes in the current exchange rate
between any two currencies is approximately
equivalent to the difference between two
countries nominal interest rate for that time this
theory is based on purchasing power parity.