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According to the Fisher effect, real interest rates are determined by the nominal interest rate and the expected rate of inflation. In other words, if inflation is expected to be high, nominal interest rates will also be high. This is because lenders will want to be compensated for the loss in purchasing power that comes with inflation.

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International Fisher Effect (IFE): Definition, Example, Formula

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The International Fisher Effect states the movement of the exchange rate of two currencies is proportional to the difference in their nominal interest rates.

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According to the Fisher effect, the nominal interest rate is equal to the sum of the real interest rate and the expected inflation rate. In other words, if the inflation rate is expected to be 2% and the real interest rate is 1%, then the nominal interest rate must be 3%.

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The Fisher effect, named after economist american economist Irving Fisher (1867–1947) known for his contributions to monetary theory, interest rates, and the quantity theory of money.

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Mexico (Inflation: 4.21%, Interest Rate: 10%)

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Higher Home Inflation and Interest Rate vs. Foreign Country

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Higher Home Inflation and Interest Rate vs. Foreign Country

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Brazil

Inflation: 1.974.83%

Interest Rate: 12.25%

IFE: -2.004

Implications

Depreciation of the Mexican peso

Imports from Brazil become more expensive

Reduced demand

Exports to Brazil become cheaper

Increased competitiveness

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Lower Home Inflation and Interest Rate vs. Foreign Country

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Lower Home Inflation and Interest Rate vs. Foreign Country

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Peru

Inflation: 1.97%

Interest Rate: 5%

IFE: 4.761

Implications

Appreciation of the Mexican peso

Imports from Peru become cheaper

Increased demand

Exports to Peru become more expensive

Reduced competitiveness

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Similar Home and Foreign Inflation and Interest Rates

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Similar Home and Foreign Inflation and Interest Rates

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Colombia

Inflation: 5.2%

Interest Rate: 9.5%

IFE: 0.456

Implications

Minimal appreciation or stable peso

Imports and exports remain stable

Balanced trade