Fisher Effect Basics
In this article, we go through the theory and show how it comes in handy in determining the currency changes in the forex.
The equation of the theory says that the real interest rate can be derived by deducting inflation from nominal rates. The Fisher Effect is in play on the money that one has in one’s savings account, for the rates being applied are actually nominal interest rates and the money may be growing at a slower rate.
For instance, if the nominal rates are 5% and inflation is at 4%, then the money in your savings account is actually only growing at 1%.
Nominal vs. Real Interest Rates
The financial return that one gets when one deposits money is based on the nominal rates. Real rates, on the other hand, highlight the actual purchasing power. Where nominal rates are reflective of monetary growth to a financial lender, real rates are reflective of how much the borrowed money can purchase.
Importance of the Fisher Effect in Money Supply
Fisher Supply highlights how the money supply impacts the nominal rates as well as inflation rates. For instance, if due to changes in the monetary policies of the central bank lead to a hike in inflation by 10%, then the nominal rates would also rise by 10%. In this sense, one can safely know that changes in the money supply will not have any impact on real rates but only on nominal ones.
International Fisher Effect (IFE)
When the concept of the Fisher Effect is extended to forex trade and analysis, it transforms into the IFE. It can be utilized to predict and interpret currency price movements since it is based on the nominal rates, rather than just inflation. As such, it states that the value differentiation between two currencies can be attributed to the differences in the two economies’ nominal rates.
IFE also provides a basis for assuming that those nations that have low rates will also have lower inflation, thereby having an increased actual value of their currency in comparison to other countries.
However, when tested empirically, the International Fisher Effect has shown ambiguous results. Other factors may affect changes in currency rates. When rates are adjusted by substantial magnitudes, in that case, IFE holds water. But, in the past few years, inflation and nominal rates have been usually low all over the globe. That is why more direct indicators, such as CPI and inflation, are used to figure out an expected change in currency rates.
The Fisher Effect highlights an important relationship in economies. Differentiating real from nominal interest by deducting the inflation; this theory can be used for a variety of purposes, including determining and expecting changes in real rates.
When applied to currencies, IFE allows one to approximate the movements in currency values. But, this is not the only indicator that lets one do so. There are many other direct factors as well that allow one to base one’s estimates on direct economic factors. Nevertheless, the Fisher Effect and IFE are used by traders and analysts to stay ahead of the game.