What’s it: International Fisher Effect shows you the changes in the exchange rates of two currencies correlate with the difference in nominal interest rates between the two countries. The term is by the name of its inventor, namely 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 principle
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 takes 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 nominal interest rates in both countries.
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%.
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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%). And 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, then the depreciation is 3.9% = (14,549 / 14,000) – 1.
Implications of the International Fisher effect
First, suppose the nominal interest rate on the domestic market is higher than that in partner countries. In that case, the domestic exchange rate should depreciate. Higher nominal interest rates reflect higher inflation expectations.
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According to Fisher, the nominal interest rate equals the real interest rate plus the inflation rate. Thus, if we expect the inflation rate to rise, the nominal interest rate will also rise.
Remember, the International Fisher effect assumes that real interest rates are equivalent across countries. Thus, the difference in nominal interest rates between countries is equivalent to the expected inflation rate difference.
Inflation represents an increase in the price level of products in the economy, including export products. Thus, domestic products will become more expensive for buyers in the partner country if domestic inflation is higher, reducing exports.
On the other hand, because inflation in partner countries is lower, their products are cheaper for domestic buyers, thus increasing import demand.
The increase in imports leads to the demand for partner countries’ currencies to increase. Domestic buyers must convert their currency to the partner country’s currency to pay for imported products.
Conversely, because exports fall, the demand for domestic currency by buyers in partner countries drops. As a result, the domestic currency’s purchasing power against the partner country’s currency weakens (depreciates).
Second, suppose the nominal domestic interest rate is lower than in the partner country. In that case, the exchange rate against the partner country’s currency should appreciate. The working principle is similar to the ones I have mentioned, but in the opposite direction.
Lower interest rates mean lower domestic inflation compared to partner countries. This means that domestic products are cheaper and products from partner countries are more expensive. Therefore, exports should increase, and imports should fall. As a result, domestic currency’s demand increases, and demand for partner countries’ currencies falls, resulting in an appreciation of the domestic currency exchange rate.
Critiques of the Fisher International effect
Critics point to several drawbacks of Fisher’s approach. They consider the concept to be less reliable in estimating short-term exchange rates.
First, nominal interest rates are not the only determinant of nominal exchange rates. International trade, which determines exchange rates, operates not only through price, but also through quality. That might offset the effects of differences in inflation (nominal interest rates) between the two countries.
Apart from that, several countries also control the exchange rate. They do this to protect the domestic economy and boost exports.
Second, capital flows do not flow freely. In Fisher’s assumption, capital flows freely between countries, leading to equal real interest rates worldwide. Because real interest rates are equal, nominal interest rates will roughly equal the difference in expected inflation in each country.
However, in practice, capital does not flow freely. Some countries still adopt restrictions on capital flows. Also, taxes, transaction costs and legal barriers cause real interest rates to differ among countries.
Third, exchange rates work not only through international trade but also through capital flows. If the domestic interest rate is higher, foreign investors favor to enter, increasing demand for the domestic currency and causing appreciation. Thus, capital movements offset the effects of differences in inflation on exchange rates.