FISHER EFFECT

• An increase(decrease)in the
expected rate of inflation will cause
a proportionate
increase(decrease)in the interest
rate in the country
NOMINAL INTEREST RATE = REAL INT

RATE +INFLATION RATE

• T h e Fish e r E ffe ct
– N o m in a lin te re st ra te is m a d e u p o f
tw o co m p o n e n ts
– A re a lre q u ire d ra te o f re tu rn
– A n in fla tio n p re m iu m e q u a lto th e
exp e cte d a m o u n t o f in fla tio n
• ( 1 + rn ) = (1 + rr) (1 + i)
• The generalized version of the Fisher
effect says that real returns are
equalized across countries through
arbitrage
• If expected real returns are higher
in one country than another, capital
will flow from country with lower
real returns to a country with
higher real returns
• This process will continue until
returns are equalized across
countries
• In equilibrium, with no government
interference, nominal interest rate
differential will approximately equal
the the anticipated inflation
differential
• Thus, currencies with high inflation
rates should bear higher interest
rates than currencies with lower low
inflation rates
• This relationship between anticipated
exchange rate movements and the
nominal level of interest rates is
called the International Fisher Effect
• If domestic interest rates exceed
foreign interest rates, then the
foreign currency must appreciate
enough (or domestic currency must
depreciate enough) to offset any
benefit of higher interest rates in
home country for the foreigners
• If domestic interest rates are less
than foreign interest rates, then
the foreign currency must depreciate
enough to offset any benefit of
higher interest rates in foreign
country for the domestic investor
•
 INTERNATIONAL FISHER
EFFECT
• It is key to understand the impact of
relative changes in nominal interest
rates among countries on the
foreign exchange value of a nation
currency
 equation is
 (1+rh)t et
 (1+rf)t eo
 Example

 Q- THE ONR YEAR INTEREST RATE IS 4% ON SWISS

FRANCS AND 13% ON US DOLLORS
A- IF THE CURRENT EXCHANGE RATE IS SF =$0.63 WHAT

IS THE EXPECTED FUTURE RATE IN ONE YEAR

ACC. TO INTERNATIONAL FISHER EFFECT

 0.63*1.13/1.04=$0.6845


B-IF A CHANGE IN EXPECTATION REGARDING FUTURE

U.S INFLATION CAUSES THE EXPECTED FUTURE
SPOTE RATE TO RISE TO $0.70 WHAT SHOULD HAPPEN
TO U.S INTEREST RATE
 0.70/0.63=(1+RUS )/1.04 OR RUS =15.56%

• A n ticip a te d exch a n g e ra te ch a n g e s
ca n b e d e rive d fro m in sp e ctin g
d iffe re n ce s in n o m in a lin te re st
ra te s
• E ffe ctive re tu rn o n h o m e in ve stm e n t
sh o u ld o n a n a ve ra g e b e e q u a lto
th e e ffe ctive re tu rn o n a fo re ig n
in ve stm e n t
•