The international Fisher effect (sometimes referred to as Fisher’s open hypothesis) is a hypothesis in international finance that suggests differences in nominal interest rates reflect expected changes in the spot exchange rate between countries. The hypothesis specifically states that a spot exchange rate is expected to change equally in the opposite direction of the interest rate differential; thus, the currency of the country with the higher nominal interest rate is expected to depreciate against the currency of the country with the lower nominal interest rate, as higher nominal interest rates reflect an expectation of inflation.
The International Fisher Effect theory was recognized on the basis that interest rates are independent of other monetary variables and that they provide a strong indication of how the currency of a specific country is performing. According to Fisher, changes in inflation do not impact real interest rates, since the real interest rate is simply the nominal rate minus inflation.
The theory assumes that a country with lower interest rates will see lower levels of inflation, which will translate to an increase in the real value of the country’s currency in comparison to another country’s currency. When interest rates are high, there will be higher levels of inflation, which will result in the depreciation of the country’s currency.
Derivation of the International Fisher effect
The International Fisher effect is an extension of the Fisher effect hypothesized by American economist Irving Fisher. The Fisher effect states that a change in a country’s expected inflation rate will result in a proportionate change in the country’s interest rate
(1+i) =(1+r) *(1+E[pi])
i is the nominal interest rate
r is the real interest rate
E[pi] is the expected inflation rate
How to Calculate the Fisher Effect
The formula for calculating the IFE is as follows:
E = [(i1-i2) / (1+ i2)] = (i1-i2)
E = Percentage change in the exchange rate of the country’s currency
i1 = Country’s A’s Interest rate
i2 = Country’s B’s Interest rate
In the short term, the International Fisher Effect is seen as an unreliable variable of estimating the price movements of a currency due to the existence of other factors that affect exchange rates. The factors also exert an effect on the prediction of nominal interest rates and inflation.
However, in the long run, the IFE is viewed as a more reliable variable to determine the effect of changes in nominal interest rates on shifts in exchange rates.