________ theory states that exchange rate between two currencies is directly affected by their interest rates

Looking for the answer to the question below related to Ratio Analysis ?

________ theory states that exchange rate between two currencies is directly affected by their interest rates

 Options:

A. IRP
B. PPP
C. Fisher`s
D. Home Foreign

The Correct Answer Is:

  • C. Fisher`s

The correct answer is C. Fisher’s theory. Fisher’s theory, specifically the Fisher effect, posits that the exchange rate between two currencies is directly affected by their interest rates. Let’s delve into why this answer is correct and why the other options are not applicable:

C. Fisher’s theory (Fisher effect):

The Fisher effect, named after the American economist Irving Fisher, is an economic theory that relates nominal interest rates, real interest rates, and inflation to exchange rates. According to the Fisher effect, there is a direct relationship between interest rates and exchange rates. Specifically:

1. Nominal Interest Rates:

The Fisher effect suggests that nominal interest rates in a country are influenced by the expected rate of inflation. If a country has higher nominal interest rates, it is often indicative of higher expected inflation.

2. Real Interest Rates:

To understand the true return on an investment, the Fisher effect separates nominal interest rates from expected inflation. It emphasizes the importance of real interest rates (nominal rates minus inflation) in determining the attractiveness of investments.

3. Exchange Rates:

The theory proposes that exchange rates move in response to changes in nominal interest rates, and these movements can be understood in terms of real interest rate differentials between two currencies. In other words, currencies with higher nominal interest rates should experience depreciation relative to those with lower rates, provided the real interest rates are the same.

This means that if a country has higher nominal interest rates than another, its currency is expected to depreciate because the higher interest rates are compensating for the expected inflation. In contrast, a country with lower nominal interest rates may experience an appreciation of its currency. The Fisher effect highlights the role of expected inflation in influencing exchange rates.

Now, let’s discuss why the other options are not correct:

A. IRP (Interest Rate Parity):

Interest Rate Parity (IRP) is a financial concept that relates interest rates and exchange rates but focuses on the relationship between interest rates and the forward exchange rate. It suggests that the interest rate differential between two currencies should be equal to the forward exchange rate premium or discount.

While interest rates play a role in IRP, it does not directly state that exchange rates are affected by interest rates in the same way as the Fisher effect does.

B. PPP (Purchasing Power Parity):

Purchasing Power Parity (PPP) is a theory that links exchange rates to relative price levels in two different countries. It posits that in the absence of transaction costs and trade barriers, exchange rates should adjust to equalize the purchasing power of two currencies for a given basket of goods.

PPP is based on the law of one price and does not primarily focus on interest rates as a direct determinant of exchange rates.

D. Home Foreign:

The term “Home Foreign” does not correspond to any well-known economic theory or model related to exchange rates. It is not a recognized theory or concept in the field of international finance. Therefore, it cannot be considered a valid answer in the context of theories explaining exchange rate movements.

In summary, Fisher’s theory, specifically the Fisher effect, directly states that exchange rates between two currencies are influenced by their respective interest rates and expected inflation.

It highlights the importance of nominal interest rates and their relationship to inflation in determining exchange rate movements. The other options, while relevant to exchange rates and interest rates, do not emphasize this direct relationship as the Fisher effect does.

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