Question

Sally Franklin is a financial advisor to Jamie Curtess, a U.S. citizen interested in learning more about how her investments will be affected by exchange rates and differences in interest rates internationally. Franklin has gathered the following information based on Curtess’s investment interests.

The current spot exchange rate: $1 = €0.74.

Europe United States

Nominal 1-year interest rate: 4% ?

Expected annual inflation: 2% 1%

Franklin also gathers the following information:

Switzerland South Africa

Nominal 1-year interest rate: 5% 7%

Expected annual inflation: 3% 5%

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According to the international Fisher relation, what is the 1-year nominal interest rate in the United States?

Answer 1

The solution to this question involves understanding the fact that the predicted future exchange rate 1 year from now would be equal under both the Purchasing Power Parity relationship (based on annual inflation) and International Fisher Effect.

Let the future exchange rate be € K / $

Current Exchange Rate = € 0.74 / $

European Inflation Rate = 2 % and US Inflation Rate = 1 %

Future Exchange Rate as per PPP:

K / 0.74 = 1.02 / 1.01 = 1.009901

K = € 0.74733 / $

Let the 1-year nominal interest rate in the US be R

Therefore, as per International FIsher Effect 0.074733 / 0.74 = (1.04) / (1+R)

1.009901 = (1.04) / (1+R)

(1+R) = 1.04 / 1.009901 ~ 0.0298 or 2.98 %