Principle that the nominal interest rate is the sum of the real interest rate and the expected rate of inflation over a specific period.
If money were free from all controls when transferred internationally, the real rate of interest should be the same in all countries. To see why this is true, suppose that real interest rates are 4 percent in Canada and 6 percent in the United States. This situation creates an arbitrage opportunity: Investors could borrow money in Canada at 4 percent, lend it in the United States at 6 percent, and earn a profit on the 2 percent spread in interest rates. If enough people took advantage of this opportunity, interest rates would go up in Canada, where demand for money would become heavier, and down in the United States, where the money supply was growing. Again, the arbitrage opportunity would disappear because of the same activities that made it a reality. That is why real interest rates must theoretically remain equal across countries.
We demonstrated earlier the relation between inflation and exchange rates. The Fisher effect clarifies the relation between inflation and interest rates. Now, let’s investigate the relation between exchange rates and interest rates. To illustrate this relation, we refer to the international Fisher effect—the principle that a difference in nominal interest rates supported by two countries’ currencies will cause an equal but opposite change in their spot exchange rates. Recall from Chapter 9 that the spot rate is the rate quoted for delivery of the traded currency within two business days.
International Fisher effect
Principle that a difference in nominal interest rates supported by two countries’ currencies will cause an equal but opposite change in their spot exchange rates.
Because real interest rates are theoretically equal across countries, any difference in interest rates in two countries must be due to different expected rates of inflation. A country that is experiencing inflation higher than that of another country should see the value of its currency fall. If so, the exchange rate must be adjusted to reflect this change in value. For example, suppose nominal interest rates are 5 percent in Australia and 3 percent in Canada. Expected inflation in Australia, then, is 2 percent higher than in Canada. The international Fisher effect predicts that the value of the Australian dollar will fall by 2 percent against the Canadian dollar.
Zimbabwe’s official rate of inflation rocketed to over 100,000 percent in 2008. Here, a citizen holds a new 10 million Zimbabwe dollar (ZWD) note just withdrawn from a local bank in Harare, Zimbabwe. A loaf of bread at the time cost about 3 million ZWD. Although it was once a model nation for others to emulate in Africa, Zimbabwe faces a crumbling infrastructure and shortages of food, fuel, and other necessities due to poor economic policies. GDP per capita fell from about $200 in 1996 to around $9 in 2007.