Understanding the International Fisher Effect (IFE): Definition and Formula

What Is the International Fisher Effect (IFE)?

The International Fisher Effect (IFE), developed by economist Irving Fisher, is an economic theory that links exchange rate movements to differences in nominal interest rates between two countries. According to the IFE, a currency with a higher nominal interest rate is expected to depreciate relative to a currency with a lower nominal interest rate.

This relationship helps predict currency movements and informs decisions in international finance. While widely referenced in economic theory, the IFE has shown mixed empirical results, making it important to consider its limitations in real-world applications.

How the International Fisher Effect (IFE) Works

The IFE uses interest rates from risk-free investments, like Treasuries, to predict currency movements. Unlike methods that only use inflation rates, it combines inflation and interest rates to understand currency changes.

The theory stems from the concept that real interest rates are independent of other monetary variables, such as changes in a nation’s monetary policy, and provide a better indication of the health of a particular currency within a global market. The IFE provides for the assumption that countries with lower interest rates will likely also experience lower levels of inflation, which can result in increases in the real value of the associated currency when compared to other nations. By contrast, nations with higher interest rates will experience depreciation in the value of their currency.

This theory was named after U.S. economist Irving Fisher.

How to Calculate the International Fisher Effect

IFE is calculated as:

$\begin{aligned}&E=\frac{i_1-i_2}{1+i_2}\ \approx\ i_1-i_2\\&\textbf{where:}\\&E=\text{the percent change in the exchange rate}\\&i_1=\text{country A's interest rate}\\&i_2=\text{country B's interest rate}\end{aligned}$​E=1+i2​i1​−i2​​ ≈ i1​−i2​where:E=the percent change in the exchange ratei1​=country A’s interest ratei2​=country B’s interest rate​

For example, if country A’s interest rate is 10% and country B’s interest rate is 5%, then country B’s currency should appreciate roughly 5% compared to country A’s currency. The rationale for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with a higher interest rate to depreciate against a country with lower interest rates.

Distinguishing Between the Fisher Effect and the International Fisher Effect

The Fisher Effect and the IFE are related models but are not interchangeable.

The Fisher Effect suggests nominal interest rates include both expected inflation and the real return rate. The IFE expands on the Fisher Effect, suggesting that because nominal interest rates reflect anticipated inflation rates and currency exchange rate changes are driven by inflation rates, then currency changes are proportionate to the difference between the two nations’ nominal interest rates.

Practical Applications of the International Fisher Effect

Research shows mixed results for the IFE, suggesting other factors may also affect currency exchange rates. Historically, in times when interest rates were adjusted by more significant magnitudes, the IFE held more validity.

However, in recent years, inflation expectations and nominal interest rates around the world are generally low, and the size of interest rate changes is correspondingly relatively small. Consumer price indexes (CPI) are often used more reliably to estimate expected currency exchange rate changes.

The Bottom Line

The International Fisher Effect (IFE) suggests that expected changes in exchange rates between two currencies align with the difference in their nominal interest rates. The theory implies that countries with higher nominal interest rates often face higher inflation, leading to potential currency depreciation.

While rooted in the broader Fisher Effect, the IFE's practical evidence is mixed, so it should be viewed as one of several tools for analyzing currency movements rather than a precise predictor. Its relevance has been most notable during periods of significant interest rate shifts, though real-world currency dynamics also depend on other economic factors.