The document discusses the international Fisher effect (IFE), which predicts that differences in nominal interest rates between two currencies will cause an equal but opposite change in their spot exchange rates. It provides the simple formula for calculating future spot exchange rates based on current rates and expected inflation and interest rates. An example calculation is shown where the US dollar is expected to depreciate against the South Korean won due to the higher nominal interest rate in the US.

1. Interest Rates and Exchange Rates
International
Fisher Effect
(IFE)
Difference in nominal interest rates
supported by two nations’ currencies
will cause an equal but opposite
change in their spot exchange rates
“Nominal” interest rate = Real + Inflation

2. International Fisher Effect
• The IFE predicts that the interest rate differential (using Nominal
interest rates) is an unbiased predictor of future changes in the spot
exchange rate.
• Assuming:
• The absence of government intervention.
• Nominal interest rate differential should reflect expected change in
exchange rate.
• Currency with the lower nominal interest rate expected to appreciate
relative to one with a higher nominal interest rate

3. Simple Version of the IFE
𝑆(𝑡+1)
𝑆𝑡
=
1 + 𝑖 𝑞
1 + 𝑖 𝑝
Where 𝑆(𝑡+1) is the Spot exchange rate of currency units of Q per
currency units of P one year from now and 𝑆(𝑡) is the current exchange
rate. 𝑖 𝑝 and 𝑖q are the respective nominal interest rates.

4. Calculating future spot rates
• Country P : Real Int rate (Rrp)= 4%/yr, Inflation (Rip)= 5%/yr
• Country Q : Real Int rate (Rrq) =5%/yr, Inflation (Riq)= 7%/yr
• Current Exchange Rate, P = 1.5Q,
• Nominal Rate for P = 9%, For Q = 12%
• Using the simple version of the IFE
𝑆(𝑡+1)
1.5𝑄/𝑃
=
1+0.12
1+0.09
• Forward rate per unit of P = S(t+1) = (1.12/1.09) * 1.5 Q = 1.54
Q

5. Example
The real interest rate on South Korean government securities
with one-year maturity is 4% and the expected inflation rate
for the coming year is 2%. The real interest rate on U.S.
government securities with one-year maturity is 7% and the
expected rate of inflation is 5%. The current spot exchange
rate for Korea won is $1 = W1,200.
Forecast the spot exchange rate one year from today.

6. Example Solution
• We know that the nominal interest rate in the US is 12%, and in South Korea is 6%.
• The international Fisher effect suggests that the exchange rate will change in an equal
amount but opposite direction to the difference in nominal interest rates (currency with
the higher nominal rate will get weaker).
• Hence, since the nominal interest rate is higher in the US than in South Korea, the dollar
should depreciate relative to the South Korean Won. In other words, 1US$ will buy fewer
SK Won.
• Using the simple IFE formula
• Forward rate per 1$ = ((1+0.06)/(1+0.12))*1200 = W1,138