Kenneth R. Szulczyk

 

1

1

1

360

1

360

 











+e

T

= +i

T

rd=id f (19)

Then we solve for e, yielding Equation 20.

1

360

1

360

1



T

+i

T

+i

e=

d

f

(20)

If the interest rates are low, then we can use a linear approximation that yields Equation 21.

 

360

T

e ifid^ (21)^

The International Fisher Effect lets analysts and economists solve for equilibrium exchange
rates. Equilibrium occurs when no capital flows from one country to another. Once investors
have exhausted their arbitrage opportunities, they stop moving their capital to the foreign
country. If the International Fisher Effect holds, subsequently, the expected cost and expected
return of lending funds becomes identical across currencies.
For example, the domestic interest rate for United States is id = 3% while the foreign
interest rate for Japan equals if = 12%. If an investment period is 90 days, subsequently, we use
the International Fisher Effect to predict the exchange rate changes. The U.S. dollar should
appreciate approximately 2.25% that we calculated in Equation 22.

    0. 0225

360

90

0.12 0.03

360

    

T

e if id^ (22)^

Result seems counterintuitive because we expect the country with the greater interest rate to
experience an appreciating currency. Usually, international investors want to earn the higher
interest rate, causing a strong demand for that country’s currency. Consequently, that country's
currency should appreciate in the short run. However, a country with a greater interest rate
would experience higher inflation, and the central bank cannot sustain the high interest rate.
Thus, that country's currency would depreciate in the long run as the central bank expands the
money supply. Hence, Equations 20 and 21 are long-run equilibrium equations.
For the second example, the Mexican Peso Crisis struck Mexico during the early 1990s,
when the Mexican peso depreciated roughly 5% per year. Interest rate differential between
Mexico and the United States (iMEX – iUS) ranged between 7% and 16%. A country with a
greater interest rate relative to another country has a depreciating currency over time.
Consequently, the Mexican peso had depreciated in December 1994, triggering Mexico’s
financial crisis.