Reference no: EM132676916

Interest Rates and Exchange Rates

The economic theory stated that interest rates and inflation rates correlate, i.e., interest rates are a good indicator of expected future inflation rates (Hill & Hult, 2020). This means that countries that expect to have high inflation rates will also have high-interest rates because governments need to compensate the investors/consumers for the decline in the value of their money as a result of high inflation rates. This relationship was formalized by economist Irwin Fisher and is known as the ‘Fisher Effect' (Hill & Hult, 2020, p. 283). According to Hill and Hult (2020), The Fisher Effect states that the:

country's "nominal" interest rate (i) is the sum of the required "real" rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I), where i = r + I. (p. 283).

The Fisher Effect almost assumed that the real interest rates will either be the same or become equalized in every country through arbitrage in a world of free trade with unrestricted capital flows (Hill & Hult, 2020). How the real interest rates between countries can be equalized through arbitrage can be explained by using two countries, A and B where Country A has a high real interest rate and Country B has a low real interest rate.

According to arbitrage, the investors will invest their capital in country A that has a high real interest rate by borrowing capital from country B that has a low real interest rate (Hill & Hult, 2020). This phenomenon will increase the demand for capital in county A thereby increasing the real interest rate; it will also increase the supply of foreign capital in county B thereby reducing the real interest rate country (Hill & Hult, 2020). This will continue until the two sets of real interest rates are equalized (Hill & Hult, 2020).

Fisher Effect essentially assumed that if the real interest rates are the same worldwide, the nominal interest rate will vary based on the expectation of the inflation rates (Hill & Hult, 2020). So if Country A has a high inflation rate than Country B, then the nominal interest rate of Country A will be higher than that of Country B (Hill & Hult, 2020).

On the other hand, Purchasing Power Parity (PPP) Theory explains a link between inflation rates and exchange rates (Hill & Hult, 2020). We also know that interest rates reflect expectations about inflation, this means that there must be a link between interest rates and exchange rates (Hill & Hult, 2020). The link between interest and exchange rates is known as the ‘International Fisher Effect (EFE)' (Hill & Hult, 2020).

The international Fisher effect states that for any two countries, "the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries." (Hill & Hult, 2020, p. 284). Explained simply, if Country A has a nominal interest rate of 10 percent and Country B has a nominal interest rate of 6 percent, then the difference between the two nominal interest rates accounts for inflation of 4 percent in County A (considering the real interest rates are the same in both countries). This 4 percent inflation rate will depreciate the currency value of Country A by 4 percent against the currency value of Country B.

This begs the question - does IFE help predict the future exchange rates based on interest rate differentials? The answer is mixed as IFE might be a good indicator, in the long run, to predict spot exchange rate fluctuations as a result of the interest rate (and inflation), but it is not a good indicator for the short-run (Hill & Hult, 2020).

Sanchez (2008) conducted a study to find the connection between interest rates and exchange rates in small open economies under flexible exchange rates and found there are distinguishing cases of expansionary and contractionary depreciation of the currency. The study was conducted to see if any empirical evidence could be drawn "by modeling interest

rate reactions aimed at offsetting variability in foreign exchange markets" (Sanchez, 2008, p. 58). The study was inconclusive and needed more empirical evidence to suggest a link between interest rate and exchange rate fluctuations.

Sanchez (2008) also mentioned two other policy measures like the foreign exchange intervention and capital controls that if combined could help in smoother exchange rate fluctuations. According to Sanchez (2008), foreign exchange interventions could be effective in dampening the volatility under special circumstances (which were not mentioned). As for capital controls, it could be effective in controlling capital investment by market participants by applying restrictive policies, which could be circumvented by market participants (Sanchez, 2008).

Considering the above shortcomings in taming exchange rate fluctuations due to interest rates, Sanchez (2008) proposed "incorporating the short term interest rate into the context of a term structure; and expanding monetary policy's targeting horizon from the current period into a more distant future." (p. 59).