International Fisher Effect (IFE)

The International Fisher Effect (IFE) is a theory in international finance that states that the nominal exchange rate between two currencies will change in an equal amount to the difference in the two countries' inflation rates. In other words, if one country's inflation rate is higher than another country's inflation rate, the value of that country's currency will decrease relative to the other country's currency.

The IFE is based on the idea that investors will seek to earn a real return on their investments, regardless of the currency in which they are denominated. If the nominal interest rate in one country is higher than the nominal interest rate in another country, but the inflation rate in the first country is also higher, then the real interest rate in the first country will be lower than the real interest rate in the second country. This will cause investors to sell the currency of the first country and buy the currency of the second country, which will cause the value of the first country's currency to decrease relative to the second country's currency.

The IFE is a useful tool for understanding how exchange rates are affected by inflation. However, it is important to note that the IFE is not always a perfect predictor of exchange rate movements. There are a number of factors that can affect exchange rates, including political and economic events, as well as investor sentiment.

The IFE can be used to calculate the expected future change in the exchange rate between two currencies. This can be done by using the following formula:

$$\Delta S = (i_1 - i_2) * (1 + \pi_1) * (1 + \pi_2)$$

where:

* $\Delta S$ is the expected future change in the exchange rate between the two currencies
* $i_1$ is the nominal interest rate in the first country
* $i_2$ is the nominal interest rate in the second country
* $\pi_1$ is the inflation rate in the first country
* $\pi_2$ is the inflation rate in the second country

For example, if the nominal interest rate in the United States is 2%, the nominal interest rate in the United Kingdom is 4%, and the inflation rate in the United States is 3%, the inflation rate in the United Kingdom is 2%, then the expected future change in the exchange rate between the US dollar and the British pound is:

$$\Delta S = (2% - 4%) * (1 + 3%) * (1 + 2%) = -0.54\%$$

This means that the US dollar is expected to depreciate against the British pound by 0.54% over the next year.

The IFE is a useful tool for understanding how exchange rates are affected by inflation. However, it is important to note that the IFE is not always a perfect predictor of exchange rate movements. There are a number of factors that can affect exchange rates, including political and economic events, as well as investor sentiment.