International Fisher Theory states that an estimated change in the current exchange rate between any two currencies is directly proportional to the difference between the two countries nominal interest rates at a particular time.
According to International Fisher Theory hypothesis, the real interest rate in a particular economy is independent of monetary variables. With the assumption that real interest rates are calculated across the countries, it can also be concluded that the country with lower interest rate would also have a lower inflation rate. This will make the real value of the country’s currency rise over time. This theory is also known as the assumption of Uncovered Interest Parity.
According to the generalized International Fisher Theory, the real interest rates should be same across the borders. But the validity of generalized Fisher theory largely depends on the integration of the capital market. That is, the capital in the market needs to be free to flow across borders. Usually the capital markets of the developed countries are integrated in nature. It has been seen that in the underdeveloped countries the currency flow is restricted.
The International Fisher theory is calculated by the following formula:
E = [(i1-i2)/(1+i2)] ≈ (i1-i2)
E represents the percentage change in exchange rate
i1 represents the interest rate of country A
i2 represents the interest rate of country B
An example may help to understand the value of the theory. For example, if the interest rate of country A is 10% and that of country B is 5%, then the currency of country B should appreciate roughly 5% compared to the currency of country A.
The International Fisher Theory observation holds that a country with higher interest rate will also be inclined to have a higher inflation rate. The International Fisher Theory also estimates the future exchange rates based on the nominal interest rate relationships. The estimate of the spot exchange rate 12 months from now is calculated by multiplying the current spot exchange rate by the nominal annual U.S. interest rate and then dividing it by the nominal annual British interest rate.