International Fisher Effect (IFE)
Candlefocus EditorIn the IFE, it is stated that if one country has a higher rate of inflation than another, exchange rates between the two currencies would move in favour of the currency with the lower rate of inflation. In other words, if a country’s inflation rate is higher than that of another country, the currency from the country with the higher inflation rate will depreciate in value. Conversely, if a country’s inflation rate is lower than another country’s, then the currency from the country with the lower inflation rate will appreciate in value.
The IFE works on the assumption that investors will always be willing to take more risk and invest in a country with higher interest rates. This is due to the promise of higher returns associated with a higher interest rate. Conversely, if a country has lower interest rates than other countries, investors will be less likely to invest in the country’s currency, as they are likely to receive funds at a slower and lower rate of return. As a result, investors are attracted to countries with higher interest rates and higher rate of returns, which causes capital to flow from countries with lower interest rates to countries with higher ones.
The IFE is an important concept for the value of a country’s currency. By understanding the relationship between interest rates and exchange rates, investors and economists can make informed decisions about foreign currency investments. Most importantly, the effects of inflation can be easily projected, allowing investors to accurately assess the potential returns they may receive from their investment. Therefore, the IFE provides a useful tool for predicting potential exchange rate movements.
Although the IFE theory is widely accepted, in recent years, direct estimation of currency exchange movements from expected inflation is becoming increasingly popular. This method is based on the idea that changes in inflation can be directly attributed to changes in exchange rates. Therefore, instead of relying on interest rates as a predictor of currency exchange, one can use inflation rates as an independent predictor of currency exchange movements.
Overall, the IFE is an important economic theory which predicts the movements of exchange rates between the currencies of different countries. Evidence for the IFE is not always consistent, however, the IFE remains an influential theory in international markets and can be used to make decisions when investing in foreign currency.