International Fisher effect

The International Fisher effect is a hypothesis in international finance that says that the difference in the nominal interest rates between two countries determines the movement of the nominal exchange rate between their currencies, with the value of the currency of the country with the lower nominal interest rate increasing. This is also known as the assumption of Uncovered Interest Parity.

Motivation

The Fisher hypothesis says that the real interest rate in an economy is independent of monetary variables. If we add to this the assumption that real interest rates are equated across countries, then the country with the lower nominal interest rate would also have a lower rate of inflation and hence the real value of its currency would rise over time. [cite book|last=Mishkin|first=Frederic S.|title=The Economics of Money, Banking, and Financial Markets (8th ed.)]

This is the opposite of what is usually seen in practice, where investors tend to move money from countries with lower nominal interest rates to those with higher nominal interest rates, in order to obtain the highest rate of return on their deposits. This practice even extends to borrowing in the country with the lower nominal interest rate to deposit the money in the country with the higher nominal interest rate, when it is profitable to do so (carry trade). These international money movement practices cause an increase in the value of the currency of the country with the higher nominal interest rate, contrary to the International Fisher effect.

Capital Market Integration

The generalized Fisher effect holds that real interest rates must be the same across borders. However, validity of the generalized Fisher effect requires capital market integration.

In order for the generalized Fisher theorem to hold, capital markets must be integrated. That is, capital must be allowed to flow freely across borders. In general, the capital markets of developed countries are integrated. However, in many less developed countries, we can observe currency restrictions and other regulation that inhibit integration.

Example

Suppose that the current spot exchange rate for U.S. Dollars into British Pounds is $1.4339 per pound. If the current interest rate is 5 percent in the U.S. and 7 percent in Britain, what is the expected spot exchange per pound rate 12 months from now according to the International Fisher Effect?

The International Fisher Effect estimates future exchange rates based on the relationship in nominal interest rates. Multiplying the current spot exchange rate by the nominal annual U.S. interest rate and dividing by the nominal annual British interest rate yields the estimate of the spot exchange rate 12 months from now ($1.4339 * 1.05) / 1.07 = $1.4071.

References