Question

assume that the one year interest rate in the united states is 7 percent and in the united kingdom 5 percent according to the international fisher effect the British pounds spot exchange rate should ____ by about _____ over the year.

Answer 1

As per international fisher effect:

E=(i1-i2)/(1+i2) which is approximately equal to i1-i2

E=i1-i2

E=percentage change in exchange Rate

i1=Country A’s interest Rate

i2=Country B’s interest rate

The logic of Fisher effect is that the country with higher interest rate will have higher inflation rate.

This will have the effect of the currency of the country having higher inflation rate will depreciate against the currency of the country having lower interest rate (consequently lower inflation).

Interest rate in the united states = 7 percent

Interest rate in the united kingdom= 5 percent

The interest rate in United Kingdom is lower. Hence British Pound will appreciate against US dollar by (7-5)=2%

Hence,

According to the international fisher effect the British pounds spot exchange rate should Appreciate by about Two percent over the year.