International Fisher effect

The international Fisher effect (sometimes referred to as Fisher's open hypothesis) is a hypothesis in international finance that suggests differences in nominal interest rates reflect expected changes in the spot exchange rate between countries. The hypothesis specifically states that a spot exchange rate is expected to change equally in the opposite direction of the interest rate differential; thus, the currency of the country with the higher nominal interest rate is expected to depreciate against the currency of the country with the lower nominal interest rate, as higher nominal interest rates reflect an expectation of inflation.

The International Fisher effect is an extension of the Fisher effect hypothesized by American economist Irving Fisher. The Fisher effect states that a change in a country's expected inflation rate will result in a proportionate change in the country's interest rate

where

This may be arranged as follows

When the inflation rate is low, the term ${\displaystyle rE[\pi ]}$ will be negligible. This suggests that the expected inflation rate is approximately equal to the difference between the nominal and real interest rates in any given country

Let us assume that the real interest rate is equal across two countries (the US and Germany for example) due to capital mobility, such that ${\displaystyle r_{\$}=r_{\mathrm {\euro} }}$. Then substituting the approximate relationship above into the relative purchasing power parity formula results in the formal equation for the International Fisher effect

where ${\displaystyle S}$ refers to the spot exchange rate. This relationship tells us that the rate of change in the exchange rate between two countries is approximately equal to the difference in those countries' interest rates.

Combining the international Fisher effect with uncovered interest rate parity yields the following equation: