Derivation of The International Fisher Effect
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, such that the Fisher effect:
can be arranged as
where
- is the nominal interest rate
- is the real interest rate
- is the expected inflation rate
The hypothesis suggests that the expected inflation rate should equal the difference between the nominal and real interest rates in any given country, such that:
where
- could be substituted with any country's currency
Assuming the real interest rate is equal across two countries due to capital mobility, such that, substituting the aforementioned equation into the expectations form of relative purchasing power parity results in the formal equation for the international Fisher effect:
where
- is the expected rate of change in the exchange rate
This equation can be rearranged as:
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