Interest rates and exchange rate

The Fisher effect describes the relationship between inflation, real interest rates and nominal interest rates. The nominal interest rate equals the real interest rates plus the expected inflation ratesIf nominal interest rate is constant, real interest rates will fall as inflation increases

Interest rates and exchange rates

Fisher Effect

- The Fisher effect describes the relationship

between inflation, real interest rates and

nominal interest rates

- The nominal interest rate equals the real

interest rates plus the expected inflation rates

- If nominal interest rate is constant, real

interest rates will fall as inflation increases

- i = r + I => r = i – I

In a world of countries and unrestricted capital

flows, the real interest rates will be the same If

they are not the same, arbitrage will equalize them

For example, = 5%, = 10%

The investor will borrow capital in US and invest it in Japan

increases, decreses => =

The differences in nominal interest rates is also = differences

in expected rates of inflation

International Fisher Effect (IFE)

- a link between nominal interest rate and exchange rate

- 2 countries, the spot exchange rates change in an equal amount but in opposite direction to the different nominal interest rates between 2 countries

Does IFE help predict future

currency movement ?

- In long run, there seem to be a relationship between nominal interest rate and spot exchange rate

- In short run, IFE is not a good predictor