The international Fisher effect (sometimes referred to as Fisher's open hypothesis) is a hypothesis in international finance that suggests differences in nominal interest rates reflect expected changes in the spot exchange rate between countries.
This suggests that the expected inflation rate is approximately equal to the difference between the nominal and real interest rates in any given country Let us assume that the real interest rate is equal across two countries (the US and Germany for example) due to capital mobility, such that
Then substituting the approximate relationship above into the relative purchasing power parity formula results in the formal equation for the International Fisher effect where
Combining the international Fisher effect with uncovered interest rate parity yields the following equation: where Combining the International Fisher effect with covered interest rate parity yields the equation for unbiasedness hypothesis, where the forward exchange rate is an unbiased predictor of the future spot exchange rate.
Also suppose the current interest rates are 5 percent in the U.S. and 7 percent in the U.K. What is the expected spot exchange rate 12 months from now according to the international Fisher effect?