International Fisher Effect (IFE): Definition, Example, Formula

What Is the International Fisher Effect?

The International Fisher Effect (IFE) is an economic theory stating that the expected disparity between the exchange rate of two currencies is approximately equal to the difference between their countries' nominal interest rates.

Key Takeaways

  • The International Fisher Effect (IFE) states that differences in nominal interest rates between countries can be used to predict changes in exchange rates.
  • According to the IFE, countries with higher nominal interest rates experience higher rates of inflation, which will result in currency depreciation against other currencies. 
  • In practice, evidence for the IFE is mixed and in recent years direct estimation of currency exchange movements from expected inflation is more common.

Understanding the International Fisher Effect (IFE)

The IFE is based on the analysis of interest rates associated with present and future risk-free investments, such as Treasuries, and is used to help predict currency movements. This is in contrast to other methods that solely use inflation rates in the prediction of exchange rate shifts, instead functioning as a combined view relating inflation and interest rates to a currency's appreciation or depreciation.

The theory stems from the concept that real interest rates are independent of other monetary variables, such as changes in a nation's monetary policy, and provide a better indication of the health of a particular currency within a global market. The IFE provides for the assumption that countries with lower interest rates will likely also experience lower levels of inflation, which can result in increases in the real value of the associated currency when compared to other nations. By contrast, nations with higher interest rates will experience depreciation in the value of their currency.

This theory was named after U.S. economist Irving Fisher

Calculating the International Fisher Effect

IFE is calculated as:

 E = i 1 i 2 1 + i 2     i 1 i 2 where: E = the percent change in the exchange rate i 1 = country A’s interest rate \begin{aligned}&E=\frac{i_1-i_2}{1+i_2}\ \approx\ i_1-i_2\\&\textbf{where:}\\&E=\text{the percent change in the exchange rate}\\&i_1=\text{country A's interest rate}\\&i_2=\text{country B's interest rate}\end{aligned} E=1+i2i1i2  i1i2where:E=the percent change in the exchange ratei1=country A’s interest rate

For example, if country A's interest rate is 10% and country B's interest rate is 5%, country B's currency should appreciate roughly 5% compared to country A's currency. The rationale for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with a higher interest rate to depreciate against a country with lower interest rates.

The Fisher Effect and the International Fisher Effect

The Fisher Effect and the IFE are related models but are not interchangeable. The Fisher Effect claims that the combination of the anticipated rate of inflation and the real rate of return are represented in the nominal interest rates. The IFE expands on the Fisher Effect, suggesting that because nominal interest rates reflect anticipated inflation rates and currency exchange rate changes are driven by inflation rates, then currency changes are proportionate to the difference between the two nations' nominal interest rates.

Application of the International Fisher Effect

Empirical research testing the IFE has shown mixed results, and it is likely that other factors also influence movements in currency exchange rates. Historically, in times when interest rates were adjusted by more significant magnitudes, the IFE held more validity. However, in recent years inflation expectations and nominal interest rates around the world are generally low, and the size of interest rate changes is correspondingly relatively small. Direct indications of inflation rates, such as consumer price indexes (CPI), are more often used to estimate expected changes in currency exchange rates. 

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