What is the International Fisher Effect?

The International Fischer effect is an exchange rate theory that was introduced by Irving Fisher around 1930's. The International Fisher effect or IFE is based on the present and the future risk free nominal interest rates. The IFE takes a somewhat different approach compared to other theories which focus on inflation.

The International Fisher effect is used to predict the future currency movements of a currency pair.

However, for the IFE to work, some assumptions are required. The International Fisher effect is known as a pure interest rate model. Fisher stated that inflationary changes do not impact the real interest rates. This is because the real interest rates are nothing but nominal interest rate minus inflation.

Although the International Fisher effect looks quite appealing, in the short term it has proven to be an unreliable way of estimating the currency movements. This is because there are a lot of other factors besides just interest rates that affect the exchange rates.

But in the long term, the International Fisher effect is seen as a reliable equation to determine the effects of changes in the respective currencies. However, many academics still question the reliability of the IFE. This is because exchange rates tend to offset the interest rate differentials.

Many developed economies make use of the consumer price index rather than the IFE to adjust their interest rates.

What is the International Fisher Effect Theory?

The International Fisher effect is primarily an economic theory which states that the expected disparity of exchange rates is approximately equal to the two currency's nominal interest rates.

The International Fisher effect is also known as IFE and is based on the analysis of interest rates that are associated with the risk free future investments. In other words, this simple means analysis of the Treasuries for example which can help to predict the future exchange rates.

The main differentiating factor with the International Fisher effect and other similar theories is that the IFE makes use of interest rates and inflation. Most other theories make use of just the inflation variable.

The IFE basis its premise on the concept that real interest rates are independent of all other variables such as changes to the monetary policy. Thus, the real interest rates provide a better indication of an economy's health.

The IFE also postulates that economies that have lower interest rates will also experience lower levels of inflation. This is expected to increase the real value of the associated currency. Conversely, economies that have higher interest rates are expected to experience a depreciation in the value of the currency.

What are nominal and real interest rates?

Nominal and real interest rates are commonly used when the context is about the interest rates of an economy. The nominal interest rate is the rate that does not account for inflation.

The nominal interest rate is the rate that is usually quoted on bonds or on loans or deposits. On the other hand, the real interest rate on the other hand is adjusted for inflation and gives the real rate of the bond or the loan or deposits.

To calculate the real interest rate, the nominal interest rate is a requirement followed by the inflation rate as well.

A simple to way to illustrate nominal and real interest rates is as follows.

Say for example you deposit $100,000 with a bank which gives you an interest rate of 5%. This is nothing but the nominal interest rate. At the end of one year, you receive $50,000. But what about inflation?

Assuming that inflation over the one year term was 2%, then the real interest rate you get is actually 3%. Thus, the interest you earn at the end of one year, when adjusted for inflation is in fact $30,000.

The formula for calculating real interest rate is subtracting the inflation rate from the nominal interest rate.

Real Interest Rate = Nominal Interest Rate – Inflation

Conversely, you can calculate the nominal interest rate as Real interest rate + inflation.

How to calculate the International Fisher Effect?

Despite some complexity in the definition, the IFE calculation is very simple.

E = (i1 - i2)/(1 + i2) = (i1 - i2)

E represents the percentage change in the exchange rate

i1 and i2 represent the interest rates of the two currencies in question

An easy way to illustrate the Fisher effect is by considering that the interest rates are 4% and 2% for i1 and i2 respectively.

Based on this, we derive with E as approximately 2%. What the calculation means is that currency of i2 will appreciate by 2% against the currency of i1.

Example of International Fisher Effect – AUDUSD

The below calculation gives an example of the AUDUSD predicted exchange rate based on the International Fisher Exchange theory.

We take the interest rates for the United States which is at 2.2% and for Australia which is 1.5%.

We then take the AUDUSD current exchange rate which is 0.7088. Based on the calculation, we get the predicted exchange rate of $0.7140 for AUDUSD over the next 12 month period,

Does the International Fisher Effect work?

The reasons for developing the Fisher effect was that Irving Fisher believed that building a pure interest rates model was a leading indicator. As a result, this could predict the future currency movements up to 12 months into the future.

However, the drawback with the International Fisher Effect model is the uncovered interest parity. The uncovered interest parity is that it is not possible to know with certainty over time the spot price or the exact interest rate.

Secondly, during the time when the International Fisher effect was introduced, most countries controlled their exchange rates due to economic and trade purposes. However, over the decades, most of the currencies are now free floating which brings to question on the effectiveness of the International Fisher effect.

The IFE has proven to be a failure especially when the purchasing power parity fails, which is one of the biggest drawbacks of this theory.

Purchasing power parity or PPP is a theory in economics which compares the currencies of two economies through a basket of common goods.

According to the purchasing power parity theory, two currencies are said to be in balance or equilibrium or at par when the basket of goods in one economy costs the same in another economy.

Given the developments in the major economies around the world, economies do not change interest rates with the same frequency as earlier, which makes the IFE not as reliable as it once was.

Also, with central banks shifting focus from interest rate targets to inflation targeting, where interest rates are determined by inflation rates, the IFE has proven to be not a practical way to predict the future exchange rates.

While the International Fisher effect has some strong theoretical foundations, the full fisher effect hasn't been supported by academics as recent as 2008. Other factors for not finding the international fisher effect is the exchange rate risk and transaction costs.

 

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