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The International Fisher Effect (IFE) is an extension of the Fisher Effect, formulated by economist Irving Fisher. This postulate holds that discrepancies in nominal interest rates between two nations reflect expectations about the evolution of their currencies exchange rates.

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In simple terms, a country with a higher nominal interest rate will experience a depreciation of its currency compared to another nation with a lower interest rate, assuming that markets are efficient and inflationary projections are properly incorporated into interest rates.

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Interest rate fluctuations have a significant impact on various aspects of the global economy, affecting investment, changing markets, monetary policy, and financial stability.

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When central banks change their nominal interest rates in response to changes in inflation, this directly affects the local currency's exchange rate. According to the IFE, if a country increases its nominal interest rates due to rising inflation, investors will demand higher returns, which, in the short term, may attract foreign capital.

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Effect of Interest Rate Adjustments on Trade and Investment

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Effect of Interest Rate Adjustments on Trade and Investment

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Attracting Foreign Capital

When a country raises its nominal interest rates, it becomes more attractive to foreign investors, as they seek higher returns on their financial assets. However, if the increase in interest rates is driven by higher inflation, the local currency could depreciate in the long term, reducing foreign investors' profits.

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Effect of Interest Rate Adjustments on Trade and Investment Attracting, Foreign Capital

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Effect of Interest Rate Adjustments on Trade and Investment Attracting, Foreign Capital

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When a country raises its nominal interest rates, it becomes more attractive to foreign investors, who seek higher returns on their financial assets. However, if the increase in interest rates is due to higher inflation, the local currency could depreciate in the long run, reducing foreign investors' profits.

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The IFE establishes that the exchange rate between two currencies must adjust to compensate for the disparity in nominal interest rates. If a country raises its interest rates, investors may migrate their capital to that currency in search of higher returns, temporarily appreciating it. However, if inflation is high, the currency will eventually lose value in proportion to the increase in prices.

In reality, this principle is not always strictly adhered to due to factors such as speculation in changing markets, government interventions, and other macroeconomic factors.

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Central Bank Strategies

Monetary institutions use the IFE to analyze the impact of interest rate changes on the exchange rate and inflation. An increase in the nominal interest rate can help curb inflation, but if it remains high, the IFE suggests that the currency's exchange rate will eventually be negatively affected.

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Interest rate changes also influence international trade. If a country raises its interest rates, its currency may temporarily appreciate, making its exports more expensive and reducing its competitiveness in global markets. Conversely, a stronger currency reduces the cost of imports, which may benefit consumers but harm local producers. If inflation remains high despite high interest rates, the currency could eventually depreciate, again benefiting exporters by making their products more affordable abroad.

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Limitations of the International Fisher Effect

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Limitations of the International Fisher Effect

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While the IFE is a useful tool for understanding the relationship between interest rates and exchange rates, it has certain limitations:

Inaccuracy in Inflation Expectations: It is assumed that markets correctly incorporate inflationary projections into interest rates, but in practice, these expectations can be erroneous.

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

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

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Higher nominal interest rates can lead to a temporary appreciation of the national currency, as they attract foreign investment seeking more attractive returns. This can also benefit imports in the short term, as a stronger currency reduces the cost of goods and services purchased abroad.

When the currency depreciates, exports become more competitive in the international market, boosting demand for domestic products. However, imports become more expensive, which could reduce the purchase of foreign goods and encourage local production.

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Case: Home inflation and interest rate are lower compared to the foreign country.

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Case: Home inflation and interest rate are lower compared to the foreign country.

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When domestic inflation and interest rates are lower than those of foreign countries, the country becomes less attractive to international investors, which can lead to capital outflows and currency depreciation. This depreciation benefits exports, as domestic goods become more competitive in the international market, boosting growth in the export sector.

In the short term, the national currency could experience moderate depreciation due to lower inflows of foreign investment. However, in the long term, if the country maintains controlled inflation and strengthens its export competitiveness, the currency could stabilize or even appreciate.

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Case: Home and foreign inflation and interest rate are similar.

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Case: Home and foreign inflation and interest rate are similar.

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Regarding imports and exports, the fact that interest rates and inflation are similar in both countries allows for the maintenance of interest rate parity, which helps prevent large inflows of speculative capital.

Regarding the national currency, it should remain stable in the short and long term, as there are no factors exerting significant pressure on the exchange rate.