Introduction
The International Fisher Effect is a measure of the relationship between nominal rates of interest and inflation rates in different countries (Hatemi 2009, p. 117). It, therefore, mediates the purchasing power of currencies and interest rates. It states that the real interest rate, which is the difference between the risk-free interest rate and the inflation rate, is maintained across countries.
A disparity in the rates of inflation of two countries is usually offset by changes in the exchange rates between the two currencies of the countries in question. Investors on the other hand move their capital from countries with low rates of interest to countries with high rates of interest which in turn lead to a change to the nominal rate of interest. This offsets the nominal-rate differences between the countries (Sundqvist 2002, p. 5).
Thus, a change in the exchange rates between any two countries has a direct proportion to the difference in the nominal interest rates of the two countries and countries with high interest rates suffer a high rate of inflation while those with lower interest rate have a low inflation rate that makes their currency value grow with time (”International Fisher Effect”, 2000, p. 1).
Empirical Tests on International Fisher Effect
Several tests to prove the validity of the International Fisher Effect have been conducted. They all fail in giving substantial support to the theory. For instance, Empirical study gives slope coefficients between nominal interest rates and inflation rates that are significantly different from unity which is a deviation from the behavior suggested by the International Fisher Effect.
It suggests that the real interest rate in any country is not dependent on inflation rates because the latter results to changes in the nominal interest rate. Thus the nominal interest rate in any country should have a direct proportion to inflation rates in the ratio one-to-one and thus the slope coefficients between nominal interest rates and inflation rates should be unity (Hatemi 2009, p. 117).
A study conducted on thirteen countries, both developed and developing to establish the relationship between Fisher Effect and International Fisher Effect showed that International Fisher Effect holds in the long run since the average annual deviations tended to zero. It was, however, evident that it does not hold in the short run because the annual deviations were too large to support validity in the short run. Another study carried out by Giddy and Dufey in 1975 to establish the relationship between nominal rate changes and the exchange rate changes, led to the disputing of the validity of the International Fisher Effect (Sundqvist 2002, p. 17).
It is quite difficult to empirically prove International Fisher Effect due to the unobservable and immeasurable nature of the expected inflation rates and the expected real interest rates which are key factors in International Fisher Effect evaluation/description. The real interest rate is considered to be a function of investor’s instincts and thus it is immeasurable (Oxelheim 1990, p.27).
Fisher used money illusion to explain the lack of empirical evidence of the International Fisher Effect. However, it has recently been shown that there exists substantial empirical evidence on the validity of the International Fisher Effect depending on the dynamics of the study. Thus the choice of study period, length of study period etc. have a significant effect on the results of empirical study on International Fisher Effect (Oxelheim 1990, p. 25).
Conclusion
Though it is true that empirical evidence of International Fisher Effect is insufficient, the International Fisher Effect theory has helped greatly in explaining and analyzing the dynamics of international money markets. It is a useful theory that cannot be proved adequately empirically due to the nature of its explanatory variables.
Reference list
Hatemi, A, (2009), “The International Fisher Effect: theory and application”. Web.
“International Fisher Effect”, (2000), Maps of World Finance. Web.
Oxelheim, L, (1990), “International Financial Integration”, Available from, Google books.
Sundqvist, E, (2002), “An Empirical Investigation of the International Fisher Effect”, Lulea University of Technology. Web.