Fisher Effect and Purchasing Power Parity

Question

Explain and discuss the significance of Fisher Effect and the Purchasing Power Parity theories to a foreign exchange dealer in the merchant bank?

Answer 1

Fisher Effect: It is an economic theory introduced by economist Irving Fisher which explains the relationship among inflation and both nominal and real interest rates. The Fisher effect defines that the real interest rate equals the nominal interest rate minus the expected inflation rate. Thus, real interest rates fall as inflation rises, unless nominal rates rise at similar rate as inflation.

For illustration, when the nominal interest rate on savings account is 4 percent and the expected rate of inflation is 3 percent, then the money in savings account is actually growing at 1 percent. The smaller the real interest rate the more longer it will take for savings deposits to nurture substantially whenever observed from a purchasing power viewpoint.

The purchasing power parity theory of exchange rate is a theory that establishes the fact that the exchange rates among currencies are in equilibrium in the event of equal opportunity in the purchasing power of each of the countries. Such precisely means that the ratio of the price level of a fixed amount of services and goods of the two countries and the exchange rate among those two countries should be equivalent.