INTERNATIONAL FISHER EFFECT

GROUP MEMBERS
ZAIN UL ABDIN FAROOQ
NAZIA TANVEER
AMIR SALEEM

I
International Fisher Effect (IFE)
 International Fisher Effect (IFE) theory uses interest rate rather than
inflation rate differentials to explain why exchange rate change over
the time.
 Closely related to PPP theory because interest rate often highly
correlated with the inflation rate.
According to Fisher effect, nominal risk free interest rates contain a real
rate of return and anticipated inflation.
 Real rate = Nominal interest rate – inflation rate
 Nominal interest rate= Real interst rate + inflation rate
If the same real return is required, differential in interest rate may be due
to differential inexpected inflation.
Relationship with Purchasing Power of
Parity
 PPP theory suggest that exchange rate movement are caused by inflation rate
differentials. Any difference in nominal interest rate could be attributed to the
difference in expected inflation.
 IFE theory suggest that foreign currencies with relatively high interest rates will
depreciate because the high nominal interest rate reflect expected inflation.
 The nominal interest rate would also be incorporated the default risk of an
investment.
 What does international Fisher
effect- IFE Means
 An economic that state that an expected change in the current exchange rate
between the two currencies approximately equivalent to the difference between
two currencies nominal interest rate for that time.
 For example; if country A’s interest rate is 10% and country B’s interest rate is 5% ,
country B’s currency should appreciated roughly 5% compared country A’s
currency.
 The rational IFE is that a country with a higher interest rate will also tend to have a
higher inflation rate. This increased amount inflation should cause the currency in
the country with high interest rate to depreciate against a country with lower
interest rate.
Using The IFE to Predict
Exchange Rate Movements

 Two steps are required when using the international Fisher effect to
predict exchange rate movements between two countries.
Apply the Fisher Effect to Derive
Expected Inflation per Country
 The first step is to derive the expected inflation rates of the two countries
based on the fisher effect’s claim that the nominal interest rate in two
countries differs because of the difference in their expected inflation. By
assuming that the real interest rate is the same in the two countries, the
difference between them in terms of the nominal interest rate is completely
attributed to the difference in their expected inflation rates.
Rely on PPP to Estimate the
Exchange Rate Movement
 The second step when using the international fisher effect to predict
movements in the exchange rate is to determine via PPP how the
exchange rate would change in response to the two countries’ expected
inflation rates as calculated in the first step. As discussed previously, the
theory of purchasing power parity argues that international trade flows
adjust in response to different inflation rates; in particular, the country with
the higher inflation increases its demand for imports and experiences a
reduced demand for its export. This shift in trade flows causes the
currency with the higher inflation to depreciate, and the shift in trade
continues until a new equilibrium is reached in which the level of
depreciation offsets the inflation differential (i.e., the point at which a
consumer’s purchasing power is the same for products in either country).
Graphical Analysis of International
Fisher Effect
Points on IFE line:
 All points along IFE line reflect the exchange rate adjustments to offset the
differential in interest rate.
 It mean investor will end up achieving the same yeild whether they invest at home
or a foreign country.

Point below the IFE line:

 Reflect the higher returns from investing in foreign deposit . Investor of the home
country could consistently increase their investment returns by establishing foreign
bank deposits.

Point above the IFE line:

 Points above the IFE line generally reflect returns from foreign country deposit that
are lower than the return possible domestically. Investor of the home country would
receive consistently lower returns from foreign investments as opposed to
investment in the home country.
 Why fisher effect does not occur
 Purchasing power has not held over certain periods.
 IFE is based on purchasing power of parity , it does not hold either.
 Because exchange rate can be affected by factors other than iflation, exchange
rate does not always adjust in accordance with the inflation differentials.