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“the relationship of the differential between the interest rates in two countries and the expected variability in the exchange rate¨

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“the Fisher Effect states that, as a consequence of a change in the money supply, the nominal interest rate varies according to long-term changes in the inflation rate”

For this reason, the currency of the country with higher rates would tend to be depreciated according to that difference.

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Unexpected changes that affect the exchange rate

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Unexpected changes that affect the exchange rate

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if an economy raises its rates, it attracts capital flows that normally appreciate its currency in the short term.

Recent studies show that the effects may depend on the time period and duration of the impact, so the “one-to-one” of the IFE is not always fulfilled.

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Obstacles in payment systems and intermediary costs

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Obstacles in payment systems and intermediary costs

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such as commissions, delays, and restrictions limit the expected impact of the IFE, reinforcing the exchange rate response to interest rate differences; high frictions attenuate or delay this adjustment.

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High levels of public debt or fiscal expectations 

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High levels of public debt or fiscal expectations 

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They can change the market response to rate hikes, since, for example, if rate increases raise the cost of public financing, the increase in a country’s risk can cause its currency to lose value, preventing it from appreciating as expected by the interest rate difference.

International organizations and central banks indicate that if fiscal and monetary policies are not well coordinated or are unreliable, the currency may depreciate rapidly.

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

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

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It reflects higher expected inflation, and therefore, investors anticipate that the value of that currency will decrease over time.

The country’s exports become more competitive because its currency is worth less, and imports become more expensive.

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

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

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The domestic currency would depreciate because high rates and inflation reduce its purchasing power and generate less confidence in its long-term stability.

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

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

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It generates confidence for investors, as they prefer to hold assets in that currency.

Imports become cheaper, benefiting consumers, while exports, on the contrary, become more expensive and less attractive.

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

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

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The domestic currency would tend to appreciate, since its low level of inflation maintains its high value and attracts foreign investment, generating higher demand for the local currency.

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c.	Home and foreign inflation and interest rate are similar

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c.	Home and foreign inflation and interest rate are similar

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There are no major reasons for the exchange rate between them to change, so imports and exports remain stable, with no significant positive or negative effects for either.

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c.	Home and foreign inflation and interest rate are similar.

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c.	Home and foreign inflation and interest rate are similar.

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Domestic currency would remain stable, because with similar economic conditions, there are no reasons for its value to change against the foreign currency.

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International Fisher Effect under exchanged rate regime shifts

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International Fisher Effect under exchanged rate regime shifts

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Reconciling Random Walks and Predictability: A Dual- Component Model of Exchange Rate Dynamics

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Reconciling Random Walks and Predictability: A Dual- Component Model of Exchange Rate Dynamics

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Reconciling Random Walks and Predictability: A Dual- Component Model of Exchange Rate Dynamics

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This paper addresses a key puzzle in international finance: whether exchange rates follow a random walk or exhibit predictable patterns. We demonstrate that exchange rates can possess a unit root while maintaining substantial predictability over certain horizons. Our model combines a stochastic trend—representing the slowly moving equilibrium exchange rate—and a stationary cyclical component capturing temporary deviations, reconciling long-term random walk behavior with medium-term predictability. This dual-component framework is essential for capturing three key features of exchange rate dynamics: expected exchange rate changes are not zero, they are highly persistent, and there is a strong relationship between exchange rate levels and expected future changes. Without the stationary component, expected exchange rate changes would be zero, and if the stochastic trend evolved too quickly, this relationship would break down. To illustrate, we extend the Bacchetta and van Wincoop (2021) framework (which generates a stationary component of the exchange rate) with a stochastic trend. Our model generates an inverted U-shaped pattern where forecast accuracy peaks at intermediate horizons and predicts that multi-year exchange rate changes are increasing multiples of one-year changes. Using data from 2000–2024 for nine inflation-targeting countries with freely floating exchange rates, we find strong empirical support for these predictions, with our model consistently outperforming the random walk benchmark in out-of-sample tests.