higher returns from foreign investing in some periods and lower foreign returns in other periods). Statistical Test of the IFE Apply regression analysis to historical exchange rates and the nominal interest rate differential.
28 Exhibit 8.8 Illustration of IFE Concept (Exchange Rate Changes Offsetting Interest Rate Differentials on Average)
29 Tests of the International Fisher Effect Limitations of the IFE The IFE theory relies on the Fisher effect and PPP Limitation of the Fisher Effect The difference between the nominal interest rate and actual inflation rate is not consistent. Thus, while the Fisher effect can effectively use nominal interest rates to estimate the market’s expected inflation over a particular period, the market may be wrong. Limitation of PPP Other country characteristics besides inflation (income levels, government controls) can affect exchange rate movements. Even if the expected inflation derived from the Fisher effect properly reflects the actual inflation rate over the period, relying solely on inflation to forecast the future exchange rate is subject to error.
30 Tests of the International Fisher Effect IFE Theory versus Reality The IFE theory contradicts how a country with a high interest rate can attract more capital flows and therefore cause the local currency’s value to strengthen (Ch. 4). IFE theory also contradicts how central banks may purposely try to raise interest rates in order to attract funds and strengthen the value of their local currencies (Ch. 6). Whether the IFE holds in reality is dependent on the countries involved and the period assessed. The IFE theory may be especially meaningful in cases when the MNCs and large investors consider investing in countries where the prevailing interest rates are very high.
32 Exhibit 8.9 Comparison of the IRP, PPP, and IFE Theories
Chapter Questions 1.If investors in the U.S. and Canada require the same real interest rate, and the nominal interest rate is 2% higher in Canada, what does this imply about expectations of U.S. inflation and Canadian inflation? What do these inflationary expectations suggest about future exchange rates? 2.Assume that several European countries that use the euro experience higher inflation than the U.S., while two other European countries experience lower inflation than the U.S. According to PPP, how will the euro’s value against the dollar be affected? 33
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