Irving Fisher a US economist presented a theory that is called International Fisher Effect. If the theory holds true the future currency exchange rates between the two countries will be exactly equal to the spot exchange rate with the incorporation of interest rates prevailing in both countries.
Assume the current spot USD/ AUD rate is 1.5 means that each USD is worth 1.5 AUD. Assume that the interest rate in the USA is 4% and in Australia, it is 3%. If the fisher effect holds true the future exchange rate will be:
Future rate = Spot rate x (1+iUSA) / (1+iAUS)
Future rate = 1.5 x (1.04) / (1.03) = 1.514
Define the Fisher effect. To what extent do empirical tests confirm
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