Theories of Exchange Rate Determination
Theories of Exchange Rate Determination
Fisher Effect
The Fisher Effect outlines how both a country’s nominal and real interest rates are related to inflation. The real interest defines the interest rate adjusted to get rid of inflationary impacts. It thus reflects the actual cost of funds incurred by the borrower and the actual yield to the investor or the lender. The nominal interest on the other hand is the price quoted on lending and borrowing transactions disregarding any fees or interest. The Fisher Effect theory states that a country’s real interest rate is equivalent to its nominal interest minus the expected inflation. This implies that an increase in inflation rates result in a fall in real interest unless the nominal interest rates increase simultaneously as the inflation rate. The theory assumes that the real interest does not change or the change is insignificant (David, 2021). It is summarized in the equation below;
(1+i) = (1+r) * (1+π), where: i is the nominal interest rate, r is the real interest rate, and π is the expected inflation rate (David, 2021).
The real interest rate is only partially realistic because individuals and most businesses have access to only one financial market as opposed to large corporations which have access to many financial markets. The Fisher Effect theory asserts that in every country and at all points in time, people expect to pay the same real interest rate. As a result, people in countries experiencing high inflation rates are expected to pay high nominal interest rates while those in low inflation countries are expected to pay low nominal interest rates (David, 2021). The theory is applied in a country’s monetary policy where central banks set nominal interest rates in an effort to prevent inflation from spiraling upwards during expansion. It also helps in measuring portfolio returns on investments.
Reference
David, P. A. (2021). International logistics: The management of international trade operations (6th ed.). Cicero Books
Entering a Foreign Market Through Exports
Entering a Foreign Market Through Exports
Theories of Exchange Rate Determination
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