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Understanding the International Fisher Effect (IFE)

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Understanding the International Fisher Effect (IFE)

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The International Fisher Effect (IFE) states that differences in nominal interest rates between two countries predict the expected change in their exchange rate.

If a country has higher interest and inflation rates, its currency is expected to depreciate.

If a country has lower interest and inflation rates, its currency tends to appreciate.
This relationship aligns with the idea that interest rate differentials compensate for expected currency movements, keeping real returns equal across countries.

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Case 1 – Home Interest > Foreign Interest

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Case 1 – Home Interest > Foreign Interest

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When the domestic interest rate is higher than the foreign rate, investors expect higher inflation in the domestic economy. According to the IFE, the domestic currency will depreciate by approximately the interest rate differential.

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Home interest rate: 6%

Foreign interest rate: 3%
➡ Expected depreciation: ≈ 3% in the domestic currency.

Impact on trade:

Exports: Increase (domestic goods become cheaper abroad).

Imports: Decrease (foreign goods become more expensive).

Summary:
High domestic rates → Currency depreciation → Export growth → Import reduction.

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Case 2 – Home Interest < Foreign Interest

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Case 2 – Home Interest < Foreign Interest

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If domestic interest and inflation are lower than abroad, the IFE predicts that the domestic currency will appreciate roughly by the rate difference.

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Home interest rate: 2%

Foreign interest rate: 5%
➡ Expected appreciation: ≈ 3% in the domestic currency.

Impact on trade:

Exports: Decrease (domestic goods become more expensive abroad).

Imports: Increase (foreign goods become cheaper).

Summary:
Low domestic rates → Currency appreciation → Fewer exports → More imports.

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Home interest rate: 4%

Foreign interest rate: 4%
➡ Expected change in exchange rate: ≈ 0%.

Impact on trade:

Exports: Remain stable.

Imports: Remain stable.

Summary:
Equal interest rates → Stable exchange rate → Balanced trade.

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Case 3 – Home Interest ≈ Foreign Interest

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Case 3 – Home Interest ≈ Foreign Interest

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When both countries have similar interest and inflation rates, the IFE indicates that the exchange rate should remain stable.

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U.S. vs Japan (2025)

U.S. interest ≈ 5.25%

Japan interest ≈ 0.25%
→ According to IFE, the yen should appreciate, but in practice, risk aversion caused temporary yen depreciation.
(Shows that IFE works theoretically but real markets add complexity.)

Mexico vs. Canada (2024)

Mexico: 10.75%

Canada: 4.5%
→ IFE predicts peso depreciation ≈ 6.25%. Indeed, the peso weakened slightly due to inflation pressure.

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USA vs Japon International Fisher Effect