Inflation, Interest Rate, and Exchange Rate: What Is the Relationship?

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ABSTRACT

A test of IFE (International Fisher Effect) theory was conducted for eight selected industrialized countries namely: Canada, France, Germany, Japan, The Netherlands, Sweden, Switzerland, and the United Kingdom. Each of these countries was used interchangeably as the home country, and foreign country to investigate the direction of the effect. Applying regression analysis to historical exchange rates and interest differentials was developed in a simplified statistical test of IFE. While caution must be exercised in applying and interpreting the theory, this information is useful in international business, export opportunities and price competitiveness of foreign imports.

INTRODUCTION

The International Fisher Effect (IFE) theory is an important concept in the fields of economics and finance that links interest rates, inflation and exchange rates. Similar to the Purchasing Power Parity (PPP) theory, IFE attributes changes in exchange rate to interest rate differentials, rather than inflation rate differentials among countries. The two theories are closely related because of high correlation between interest and inflation rates. The IFE theory suggests that currency of any country with a relatively higher interest rate will depreciate because high nominal interest rates reflect expected inflation. Assuming that the real rate of return is the same across countries, differences in interest rates between countries may be attributed to differences in expected inflation rates.

One of the problems affecting consumers and the world economy is exchange rates fluctuations and interest rates disparities. Among others, exchange rates fluctuations can create inefficiency and distort world prices. Moreover, the long term profitability of investment, export opportunities and price competitiveness imports are all impacted by long-term movements in exchange rates, hence international investors/companies usually have to pay very close attention to countries' inflation. International businesses engaging in foreign exchange transactions on daily basis could benefit by knowing some short-term foreign exchange movements.

LITERATURE REVIEW

This theory is very attractive because it focuses on the interest-exchange rates relationship. Does the interest rate differential actually help predict future currency movement? Available evidence is mixed as in the case of PPP theory. In the long-run, a relationship between interest rate differentials and subsequent changes in spot exchange rate seems to exist but with considerable deviations in the short run (Hill, 1997). The international Fisher effect is known not to be a good predictor of short-run changes in spot exchange rates (Cumby & Obstfeld, 1981).

Thomas (1985) conducted a test of the IFE theory by examining results of purchasing future contracts of currencies with higher interest rate that contained discounts (relative to the spot rate) and selling futures on currencies with low interest rate that contained premiums. Contrary to the IFE theory the study found that 57 percent of the transactions created by this strategy were profitable. The average gain was higher than the average loss. If the IFE theory holds, the high interest rate currencies should depreciate while the low interest rate currencies should appreciate, therefore yielding insignificant profits by the transactions.

A study by Madura and Nosari (1984) simulated a speculative strategy by borrowing currency with the lowest quoted interest rate and invested in the currency with the highest interest rate. After the loan repayment at the end of the investment period, it was found that the difference between return on the investment and the cost of borrowing (spread) was usually positive. This is in contrary to the IFE theory.

In a different but related study, Cheung et al. (1995) found more positive evidence for the support of the PPP hypothesis. …

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