Please define and explain the “Fisher Effect”:
Fisher effect shows the relationship between the real rates, nominal rates and inflation.
Fishers effect states that the spot exchange rate should change to adjust for differences in interest rates between two countries.
It states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries.
The justification for Fisher effect is that investors much be rewarded or penalised to offset the expected change in exchange rates.
It implies that the real rate of return must be constant across countries. If it is not, investors will move their money to the country with the highest rate of return.
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