UNIT II (IFFD)

The Fisher Effect

What is the Fisher Effect?
The Fisher Effect is an economic hypothesis stating that the real interest rate is equal to the
nominal rate minus the expected rate of inflation.

How Does the Fisher Effect Work?

In the late 1930s, U.S. economist Irving Fisher wrote a paper which posited that a country's
interest rate level rises and falls in direct relation to its inflation rates. Fisher mathematically
expressed this theory in the following way:

R Nominal = R Real + R Inflation

The equation states that a country's current (nominal) interest rate is equal to a real interest
rate adjusted for the rate of inflation. In this sense, Fisher conceived of interest rates, as the
prices of lending, being adjusted for inflation in the same manner that prices of goods and
services are adjusted for inflation. For instance, if a country's nominal interest rate is six
percent and its inflation rate is two percent, the country's real interest rate is four percent
(6% - 2% = 4%).
The fisher equation formula can be re-written as

(1 + i) = (1 + r) (1 + π)

Where:
i – the nominal interest rate
r – the real interest rate
π – the inflation rate

However, one can also use the approximate version of the formula:
i≈r+π
Why Does the Fisher Effect Matter?
The Fisher effect is an important tool by which lenders can gauge whether or not they are
making money on a granted loan. Unless the rate charged is above and beyond
the economy's inflation rate, a lender will not profit from the interest. Moreover,
according to Fisher's theory, even if a loan is granted at no interest, a lending party would
need to charge at least the inflation rate in order to retain purchasing
power upon repayment.
 Pls visit the link below for further reading
https://www.youtube.com/watch?v=mFI58RRCDbs
International Fisher Effect
What is the International Fisher Effect (IFE)?

The International Fisher Effect (IFE) states that the difference between
the nominal interest rates in two countries is directly proportional to
the changes in the exchange rate of their currencies at any given time.
Irving Fisher, a U.S. economist, developed the theory. The International
Fisher Effect is based on current and future nominal interest rates, and
it is used to predict spot and future currency movements.
How the International Fisher Effect was Conceptualized

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.
The International Fisher Effect (IFE) theory suggests that currencies with
higher interest rates will depreciate because the higher nominal rates
reflect higher expected inflation.
Hence, investors hoping to capitalize on a higher foreign interest
rate should earn a return no higher than what they would have earned
domestically.
 Pls visit link below for more information

https://www.youtube.com/watch?v=lJlsPals_HY