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According to the Fisher effect, the nominal interest rate is composed of two parts.

Expected interest rate

Statistical value expected for the interest rates.

Real interest rate

Returns of an investment viewed from the savers’ perspective and taking into consideration the expected inflation.

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The IFE is based on the analysis of interest rates associated with present and future risk-free investments, such as Treasuries, and is used to help predict currency movements. This contrasts with other methods that solely use inflation rates in the prediction of exchange rate shifts, instead functioning as a combined view relating inflation and interest rates to a currency's appreciation or depreciation.

·         The International Fisher Effect (IFE) states that differences in nominal interest rates between countries can be used to predict changes in exchange rates.

·         According to the IFE, countries with higher nominal interest rates experience higher rates of inflation, which will result in currency depreciation against other currencies.

·         In practice, evidence for the IFE is mixed and in recent years direct estimation of currency exchange movements from expected inflation is more common.

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Home inflation and interest rate are higher compared to the foreign country.

§  There will exist a gap in the market, such as a significant difference between interest rates in the domestic country and abroad. This gap can be exploited by investors to achieve higher returns in the domestic country, resulting in a flow of capital towards that country in search of more lucrative investment opportunities.

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Home and foreign inflation and interest rate are similar:

§  In a situation where both home and foreign countries have similar levels of inflation and interest rates, it implies:

·         Comparable nominal interest rates, leading to balanced capital flows between the two countries.

·         Stable currency exchange rates with minimal pressure for significant changes.

·         Balanced trade relations due to similar pricing environments for goods and services.

·         Overall, it suggests a balanced economic environment between the two countries with limited arbitrage opportunities based on interest rate differentials.