In foreign exchange terminology, the International Fisher Effect is based on the idea that a country with a higher interest rate will have a higher rate of inflation which, in turn, could cause its currency to depreciate. In theoretical terms, this relationship is expressed as an equality between the expected percentage exchange rate change and the difference between the two countries’ interest rates, divided by one plus the second country’s interest rate. Because the divisor approximates 1, the expected percent exchange rate change roughly equals the interest rate differential.

Putting the International Fisher Effect or IFE into practice would mean that exchange rates change based on nominal interest rate differentials and independent of inflation rates. An example of using the IFE to forecast exchange rate shifts would be if the U.S. nominal interest rate was at 1%, but the Australian rate was at 3%, then the Aussie would be expected to rise by 2% against the U.S. Dollar.

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