International Fisher Effect

The International Fisher Effect (IFE) elucidates that the difference in nominal interest rates reflects the currency exchange rate between two countries. Irvin Fisher introduced the theory in the 1930s. Irvin was an American economist. This theory is used for predicting spot currency variation.

The theory claims that if a country's domestic nominal interest rate is higher than its trading pair, then the domestic currency exchange rate is likely to decline. The theory makes certain assumptions that deviate from real-world scenarios.

• The International Fisher Effect suggests that the difference in nominal rates of return causes the dissimilarity between currency exchange rates.
• The nominal interest is not adjusted for inflation. Instead, banks use nominal interest rates to express the interest imposed on loans—it does not consider hidden fees, inflation, and other charges.
• When inflation increases, the nominal interest rate also increases. Similarly, when deflation occurs, nominal interest rates plummet.
• If RR _nominal denotes the nominal rate of return, and RR _real denotes the real rate of return, then the international fisher theory formula is RR _nominal ​= (1 + RR _real​) x (1 + Inflation Rate)

The international Fisher effect elucidates that the difference in nominal interest rates reflects the exchange rate between two countries. Therefore, it is used to calculate and predict a nation's inflation rate.

Before venturing further, let us first define the nominal interest rate. In finance and economics, the term 'nominal interest rate' refers to the interest rate that is not adjusted for inflation. However, it is closely linked to inflation; the nominal interest rate also increases when inflation increases. Similarly, when deflation occurs, nominal interest rates plummet.

Banks and financial institutions use nominal interest rates to express the interest imposed example, when a bank offers car loans at 10% interest; the banker is referring to the nominal interest rate. That is, it does not consider hidden fees, inflation, and other charges.

The real interest rate, therefore, is the sum of the nominal interest rate and the projected inflation rate. For investors, the real interest rate is more important.

The international fisher effect formula is as follows.

RR _nominal ​= (1 + RR _real​) x (1 + Inflation Rate)

In this equation,

• RR_nominal denotes the nominal rate of return.
• RR_real denotes the real rate of return.

Now, let us look at the international Fisher effect calculation.

Let us consider two currencies: the US dollar To Indian Rupee. Let us assume that the currency pair exchange rate for USD/INR is 81.99. In this scenario, India's nominal interest rate is 4% and the US’s nominal interest rate is 5%.

To calculate the future spot rate, the current spot exchange rate is multiplied by the current foreign and domestic interest ratio.

Thus,

• Expected Future Spot Rate = 81.99 (1.04/1.05)
• Expected Future Spot Rate = 81.209

The future spot exchange rate of USD/INR is 81.209. So, according to Fisher’s theory, due to the decline in the spot exchange rate from 81. concerning the Indian rupee will lose its future value.

Current USD investors will get a lower interest rate on it, but they will earn profits when the USD value increases (concerning the Indian Rupee).

Following are the international fisher effect advantage and disadvantages.

• Investors find it useful, as it helps them determine an investment’s real rate of return.
• It is used as an indicator to predict future inflation (of a country). Analysts, use the change in interest rates to determine inflation rate projections.

Now, let us look at the disadvantages.

• It assumes that capital has a free flow. When this does not occur, the projections deviate from real-world market conditions.
• The nominal rate of return cannot be considered the most accurate indicator of exchange rates. Nevertheless, even though central banks try to control it, they've had moderate success.
• Many economists believe that this method of calculating inflation lacks accuracy. But, again, the overt reliance on market rates is the limitation. Markets are volatile; they are unpredictable by definition; using market rates to predict inflation can result in false positives.

• The International Fisher Theory elucidates the difference in nominal interest rates between two countries. On the other hand, interest rate parity is a scenario where the forward discount At the same time, higher interest currency offsets the differential between the interest rates of two countries.
• The international fisher theory claims that high-interest rates lead to high inflation. The interest rate parity claims that an investor cannot earn more by investing in a foreign country that offers higher interest on deposits and investments.
• The International Fisher Theory cites the forward rate of foreign currency as the cause behind the difference in interest rates. In comparison, the interest rate parity concept defines the disparity between foreign currency spot rates.

• The Fisher Effect signifies the variation in nominal interest rates to indicate inflation; it does not associate the concept with currency exchange. In contrast, the International Fisher Theory connects the dissimilarity of currency exchange rates with the nominal interest rates of the two countries.
• The Fisher Effect elaborates that the real rate of return is equal to the nominal rate minus inflation; IFE simply extends the concept to currency markets.
• The Fisher Effect claims that monetary measures dictate real interest rates. On the other hand, IFE claims that the forward rate of foreign currency causes a difference in interest rates.

This article has been a guide to what is International Fisher Effect. Here, we explain its formula, calculation, advantages, and relation with interest rate parity. You can learn more about it from the following articles -

• Nominal vs Real Interest Rate
• Discriminant Analysis
• Black Litterman Model