Question

B. 1) Countries Mali and South Africa have their interest rates to be 6% and 12%, respectively. If their currencies trade according to 50 CFA francs buy one rand in the spot market, what will their future spot rate be in the aforementioned context? 2) Define IFE and explain the fact of how it occurs. Is there any deviation from it?

Answer 1

1) Calculation of future spot rate:

Given :  

Mali interest rate = 6%

South Africa(SA) interest rate = 12%

Spot Rate (SR) : 1 Rand = 50 CFA Francs

Formula:

Future Spot Rate = CFA Francs SR * (1+ Mali interest rate) / (1+ SA interest rate)

= 50 CFA Francs * (1+0.06) / (1+0.12)

= 47.32 CFA Francs

2) IFE :

• The International Fisher Effect (IFE) states that differences in nominal interest rates between countries can be used to predict changes in exchange rates.
• According to the IFE, countries with higher nominal interest rates experience higher rates of inflation, which will result in currency depreciation against other currencies.
• In practice, evidence for the IFE is mixed and in recent years direct estimation of currency exchange movements from expected inflation is more common.