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What’s it? The International Fisher Effect shows that changes in the exchange rates of two currencies correlate with the difference in nominal interest rates between the two countries. The term is named after its inventor, Irving Fisher, an American economist.
This hypothesis is important for predicting the movement of the spot currency and future spot prices. Long story short, when the domestic nominal interest rate is higher than its rate in the trading partner, we expect the domestic currency exchange rate to depreciate against the partner country’s currency.
International Fisher Effect Explained
Fisher emphasized that interest rates provide a strong indication of the performance of a country’s currency. In looking at the relationship between the difference in nominal interest rates and changes in exchange rates, he makes several assumptions:
- Capital freely flows between countries
- Real interest rates are the equal between countries in the world
- Difference in nominal interest rates between countries equals expected inflation (expected inflation)
- Capital markets are internationally integrated
- No currency controls
Meanwhile, the international Fisher effect formula is as follows:
The Fisher equation above shows that the percentage change in the exchange rate between two countries is roughly equal to the difference between their nominal interest rates.
Let’s take two currencies, the US dollar (USD) and the rupiah (IDR). Currently, the IDR/USD spot rate is 14,000, and the US interest rate is 2.0%, while Indonesia is 6.0%.
Based on the formula above, because Indonesia’s interest rate is higher than the interest rate in the United States, the rupiah exchange rate against the US dollar will depreciate. The percentage depreciation is approximately 4% (6% -2%). Specifically, we can calculate the rupiah exchange rate using the second formula above:
et = [(1 + 6%) / (1 + 2%) x 14,000] = 14,549
If we use it as a percentage, the depreciation is 3.9% = (14,549 / 14,000)—1.
Implications of the International Fisher Effect
The International Fisher Effect proposes a relationship between interest rates, inflation, and exchange rates. By analyzing the differences in nominal interest rates between countries (interest rate differentials), we can gain insights into how these factors might influence currency movements.
Higher domestic interest rates and currency depreciation
A higher nominal interest rate in a country compared to its partner suggests an anticipation of future inflation. Investors demand a higher return on their investments to compensate for the expected decrease in purchasing power of the currency. This concept aligns with the Fisher equation, which states that the nominal interest rate is roughly equal to the real interest rate (the return on investment excluding inflation) plus the expected inflation rate.
Due to the expectation of higher inflation, domestic products become relatively more expensive compared to imports from partner countries with lower expected inflation. This scenario triggers a shift in trade patterns:
- Export decline: Domestic products become less attractive to foreign buyers due to their higher prices, potentially leading to a decrease in export volumes.
- Import increase: Lower-priced imports from partner countries become more attractive to domestic buyers, potentially leading to a rise in import volumes.
The anticipated inflation and trade flow changes lead to a depreciation of the domestic currency:
- Increased demand for partner’s currency: The rise in imports necessitates exchanging domestic currency for the partner country’s currency to pay for these imports, driving up demand for the latter.
- Decreased demand for domestic currency: The decline in exports leads to a decrease in foreign demand for the domestic currency. As foreign investors are less enthusiastic about holding a currency with an anticipated decrease in purchasing power, they may sell their holdings of the domestic currency.
The combined effects of higher import demand and lower export demand weaken the domestic currency’s purchasing power, causing it to depreciate relative to the partner country’s currency. This depreciation can help offset the inflation differential by making domestic exports more competitive in the international market.
Lower domestic interest rates and currency appreciation
A lower nominal interest rate in a country compared to its partner suggests an expectation of lower future inflation. Investors are satisfied with a lower return because they anticipate the currency’s purchasing power to remain stable or even increase.
Lower expected inflation makes domestic products relatively cheaper compared to imports:
- Export increase: Domestic products become more attractive to foreign buyers due to their lower prices, potentially leading to a rise in export volumes.
- Import decrease: Higher-priced imports from partner countries become less attractive to domestic buyers, potentially leading to a decline in import volumes.
The anticipated lower inflation and trade flow changes can lead to an appreciation of the domestic currency:
- Increased demand for domestic currency: The potential rise in exports necessitates foreign buyers to exchange their currency for domestic currency to pay for these exports, driving up demand for the domestic currency.
- Decreased demand for partner’s currency: The potential decrease in imports leads to a decline in demand for the partner country’s currency. As foreign investors may find the domestic currency with lower expected inflation more attractive, they may increase their holdings of the domestic currency.
The combined effects of higher export demand and lower import demand strengthen the domestic currency’s purchasing power, causing it to appreciate relative to the partner country’s currency. This appreciation can help reduce inflationary pressures by making imports cheaper for domestic consumers.
Limitations of the International Fisher Effect for predicting exchange rates
The International Fisher Effect (IFE) offers a theoretical lens for understanding how interest rates, inflation, and exchange rates interact. However, it’s crucial to recognize the limitations of this theory, particularly for short-term predictions. Real-world factors like trade quality, government intervention, and imperfect capital mobility can influence exchange rates in ways not fully captured by the IFE.
Beyond price: quality matters in trade
The IFE focuses on nominal interest rates (reflecting inflation expectations) as the main driver of exchange rates through international trade. Critics argue that trade isn’t solely driven by price competitiveness. The quality of exported goods also plays a significant role.
For instance, a country with higher inflation might offer cheaper exports, but if the quality is inferior, foreign buyers may be hesitant to purchase them. This disconnect between price and quality can weaken the correlation between interest rate differentials and exchange rate movements.
Government intervention and exchange rate pegs
The IFE assumes freely floating exchange rates, where market forces determine the value of currencies. However, many governments intervene in the foreign exchange market to achieve specific economic goals. This intervention can take two main forms:
- Fixed exchange rates: Some countries peg their currency to a stronger currency or a basket of currencies, essentially fixing the exchange rate. This intervention disrupts the relationship between domestic interest rates and the exchange rate, as the central bank prioritizes maintaining the peg over influencing currency value through interest rates.
- Managed floats: Many countries operate under a managed float system, where they allow their currencies to fluctuate within a band but intervene to prevent excessive volatility. These interventions can dampen the direct impact of interest rate differentials on exchange rates.
Imperfect capital mobility and unequal real interest rates
A core assumption of the IFE is the free flow of capital across borders. This free flow would lead to similar real interest rates (interest rates adjusted for inflation) globally. In reality, capital mobility faces limitations due to factors like:
- Capital controls: Governments may impose restrictions on capital inflows or outflows to manage their economies or protect domestic industries. These controls can significantly hinder the free movement of capital.
- Transaction costs: Transferring funds internationally involves fees and other costs. These costs can discourage some investors from seeking higher returns abroad, limiting capital mobility.
- Legal barriers: Bureaucratic hurdles, regulatory differences, and political instability in certain countries can deter foreign investment, further hindering capital flows.
These limitations prevent real interest rates from being perfectly equal across countries. As a result, the predicted relationship between interest rate differentials and exchange rates may not always hold true.
Capital flows and exchange rate movements
The IFE primarily focuses on how interest rates influence trade flows, which then affect exchange rates. However, capital flows themselves can also directly impact exchange rates. If a country offers a higher interest rate, it can attract foreign investors seeking higher returns. This increased demand for the domestic currency to purchase those assets can lead to appreciation, even if the inflation differential isn’t significant. In essence, capital flows can sometimes counteract the predicted effects of interest rates on exchange rates.
