Fisher Effect and the Purchasing Power Parity

Describe and discuss the relevance of the Fisher Effect and the Purchasing Power Parity theories to a foreign currency dealer in a merchant bank

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vinay kidangan

  • Mar 1st, 2012

Fisher Effect

An economic theory proposed by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.

For example, if the nominal interest rate on a savings account is 4% and the expected rate of inflation is 3%, then money in the savings account is really growing at 1%. The smaller the real interest rate the longer it will take for savings deposits to grow substantially when observed from a purchasing power perspective.

Purchasing Power Parity Theory of Exchange Rate is a theory, which establishes the fact that the exchange rates between currencies are in equilibrium in the event of equality in the purchasing power of each of the countries. This precisely means that the ratio of the price level of a fixed amount of goods and services of the two countries and the exchange rate between those two countries must be equivalent

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