Interest rates and exchange rate

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