What Is the International Fisher Effect (IFE)?

What Is the International Fisher Effect (IFE)?

I'm going to explain the International Fisher Effect, or IFE, directly to you. This economic theory states that the expected disparity between the exchange rate of two currencies is approximately equal to the difference between their countries’ nominal interest rates.

Key Takeaways

Let me outline the essentials of the IFE for you. It states that differences in nominal interest rates between countries can be used to predict changes in exchange rates. According to the IFE, countries with higher nominal interest rates experience higher rates of inflation, which will result in currency depreciation against other currencies. In practice, evidence for the IFE is mixed, and in recent years, direct estimation of currency exchange movements from expected inflation is more common.

Understanding the International Fisher Effect (IFE)

You need to know that the IFE is based on the analysis of interest rates associated with present and future risk-free investments, such as Treasuries, and it's used to help predict currency movements. This contrasts with other methods that solely use inflation rates in the prediction of exchange rate shifts, instead functioning as a combined view relating inflation and interest rates to a currency’s appreciation or depreciation.

The theory stems from the concept that real interest rates are independent of other monetary variables, such as changes in a nation’s monetary policy, and provide a better indication of the health of a particular currency within a global market. The IFE assumes that countries with lower interest rates will likely also experience lower levels of inflation, which can result in increases in the real value of the associated currency when compared to other nations. By contrast, nations with higher interest rates will experience depreciation in the value of their currency.

This theory was named after U.S. economist Irving Fisher.

Calculating the International Fisher Effect

Here's how you calculate the IFE. It's done as E = (i1 - i2) / (1 + i2) ≈ i1 - i2, where E is the percent change in the exchange rate, i1 is country A’s interest rate, and i2 is country B’s interest rate.

For example, if country A’s interest rate is 10% and country B’s interest rate is 5%, then country B’s currency should appreciate roughly 5% compared to country A’s currency. The rationale is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with a higher interest rate to depreciate against a country with lower interest rates.

The Fisher Effect and the International Fisher Effect

Understand that the Fisher Effect and the IFE are related models but are not interchangeable. The Fisher Effect claims that the combination of the anticipated rate of inflation and the real rate of return are represented in the nominal interest rates. The IFE expands on the Fisher Effect, suggesting that because nominal interest rates reflect anticipated inflation rates and currency exchange rate changes are driven by inflation rates, then currency changes are proportionate to the difference between the two nations’ nominal interest rates.

Application of the International Fisher Effect

When applying the IFE, empirical research has shown mixed results, and it's likely that other factors also influence movements in currency exchange rates. Historically, in times when interest rates were adjusted by more significant magnitudes, the IFE held more validity. However, in recent years, inflation expectations and nominal interest rates around the world are generally low, and the size of interest rate changes is correspondingly relatively small. Direct indications of inflation rates, such as consumer price indexes (CPI), are more often used to estimate expected changes in currency exchange rates.

Who Is the International Fisher Effect Named for?

The International Fisher Effect (IFE) is named after its creator, economist Irving Fisher. He designed it in the 1930s.

Who Was Irving Fisher?

Irving Fisher (1867–1947) was a Yale University-trained economist who made numerous contributions to neoclassical economics in the studies of utility theory, capital, investment, and interest rates. Neoclassical economics looks at supply and demand as the primary drivers of an economy.

What Is the International Fisher Effect Based on?

The International Fisher Effect (IFE) is based on present and future risk-free nominal interest rates rather than pure inflation. It is used to predict and understand present and future spot currency price movements.

The Bottom Line

To wrap this up, the International Fisher Effect (IFE) is an economic theory. It states that the expected disparity between the exchange rate of two currencies is approximately equal to the difference between their countries’ nominal interest rates. According to the IFE, countries with higher nominal interest rates experience higher rates of inflation, which will result in currency depreciation against other currencies. In practice, evidence for the IFE is mixed.