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Another Theory – International Fisher Effect (IFE)

International Fisher Effect (IFE)

• The international Fisher effect (IFE) theory suggests that

currencies with higher interest rates will depreciate

because the higher rates reflect higher expected inflation.

• Hence, investors hoping to capitalize on a higher foreign

interest rate should earn a return no better than what they

would have earned domestically.

• If the British rate on 6-month deposits were 2% above the

U.S. interest rate, the £ should depreciate by

approximately 2% over 6 months. Then U.S. investors

would earn about the same return on British deposits as

they would on U.S. deposits.

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Why the IFE Does Not Always Occur

• Since the IFE is based on PPP, it will not hold when PPP

does not hold.

• For example, if there are factors other than inflation that

affect exchange rates, the rates will not adjust in

accordance with the inflation differential.

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Furthermore

• Assume that inflation in the US is expected to be

•

•

•

•

moderate

Therefore people will save more money since they are

less concerned to the possibility due to inflation.

Therefore there is a large supply of loanable funds

Therefore a low demand for loanable funds

Therefore a low Nominal Interest Rate.

Therefore the Nominal Interest Rate in the US should be

lower than in Canada because inflation is lower.

Real interest rate is the Nominal Rate of interest minus inflation

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The Fisher Effect Suggest:

• That the Nominal Interest Rate contains two components

1. Expected inflation

2. Real rate of interest

1. The “real rate of interest” is the Nominal Interest Rate minus the

expected inflation rate.

3. The International Fisher Effect is the effect to two

countries and the expected change in the exchange

rate. It suggest that difference in the Nominal Interest

Rate in the two countries is due to the difference in

expected inflation between the two countries.

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Implications of the Fisher Effect

• Currencies with a high interest rate will therefore have a

high expected inflation rate.

• Example:

US interest rate 8% and 5% in Japan the expected real

rate of return is 2% in each country

• US inflation rate is expected to be 6% - Japan 3%

• According to the PPP theory the Japanese yen is expected to

appreciate by the expected inflation differential of 3%

• If exchange rates change as expected – Japanese investors who

attempt to capitalize on the higher US interest rate will earn a similar

rate as they could have earned in there own country.

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Comparison of IRP, PPP, and IFE Theories

Interest Rate Parity

(IRP)

Interest Rate

Differential

Fisher

Effect

Forward Rate

Discount or Premium

Inflation Rate

Differential

Purchasing

Power Parity

International

Fisher Effect (IFE)

(PPP)

Exchange Rate

Expectations

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Vietnam Interest Rate History

US Interest Rate History

International Executive Master of Business Administration

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