Introduction to Finance

international Fisher eff ect (IFE)
 
theory
 
states that a country with a relatively lower nominal 
interest rate (due to a lower expected infl ation rate) will have its currency appreciate relative 
to a country with a relatively higher interest rate.
purchasing power parity (PPP) 
currency of a country with a 
relatively lower infl ation rate will 
appreciate relative to the currency 
of a country with a relatively higher 
infl ation rate
international Fisher eff ect (IFE) 
currency of a country with a 
relatively lower nominal interest 
rate (due to a lower expected 
infl ation rate) will have its currency 
appreciate relative to a country with 
a relatively higher interest rate
3
We will cover the factors that determine market interest rates in detail in Chapter 8.

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6.4 Factors that Aff ect Currency Exchange Rates
141
We can modify equation 6.3 to include relative interest rates instead of expected infl ation 
rates as follows:
Expected % FC Change =
1 + IntR
hc
1 + IntR
fc
−1 (6.4)
IntR
hc
is the nominal interest rate for the home country and the IntR
fc
is the nominal interest 
rate for the foreign country.
For example, if U.S banks are off ering a 5 percent interest rate on one-year deposits and 
euro member banks are off ering a 4 percent interest rate on comparable one-year deposits, we 
can estimate the expected percent change in the euro, as follows:
Expected % FC Change =
1.05
1.04
−1
Expected % FC Change = 1.0096 − 1 = .0096, or .96%
Thus, based on relative one-year bank deposit interest rates, IFE theory suggests that the euro 
is expected to appreciate by .96 percent over the next year.