International Fisher Effect or generalized version of the Fisher effect is a combination of:
a. PPP theory and Fisher’s open proposition.
b. Fisher’s open and closed proposition.
c. PPP theory and Fisher’s closed proposition.
d. None of the above.
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The correct option is "PPP theory and Fisher’s closed proposition" or option C.
According to the generalized International Fischer Effect model interest rates across borders should be the same. The transaction costs for taking funds across borders have not been considered here.
If we consider two nations with differing interest rates, the International Fisher Effect postulates depreciation in the currency of the nation with a higher interest rate and an appreciation in the exchange rate of the currency of the nation with the lower interest rate.
For example if the US has an interest rate of 2% and India has an interest rate of 8% and right now $1 = INR 50, after 1 year the exchange rate would be $1 = 50*1.08/1.02 = INR 52.94.
If a person were to try to benefit from the interest rate difference between the two nations he would find that after a year no net gains are made. In the example provided earlier it can be seen that 1 USD invested today in India is equal to INR 50. The 8% interest rate makes this equal to INR 50*1.08 after a year. But as the INR depreciates to 52.94, it would be equal to $50*1.08 / 52.94 = $1.02, which is the same that a person would have earned if the amount had been invested in the US.
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