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Journal of Business Management and Entrepreneurship 2010 • September • Volume: 1 • Issue: 9

Finance Considerations of the

International Fisher Effect:

Empirical Manifestations in the

Short-run and the Long-run

ABSTRACT

Eiteman, Stonehill, and Moffett (2007) noted the straight-forward definition of

the effect with, The relationship between the percentage change in the spot

exchange rate over time and the differential between comparable interest rates

Samuelson and Nordhaus (1995) depicted the relationship between the return on capital

and the determination of interest as follows:

Consider an idealized perfectly competitive world without risk or inflation. In deciding

whether to make an investment, a profit-maximizing firm will always compare its cost of

funds with the rate of return on capital. If the rate of return is higher than the market

interest rate at which the firm can borrow funds, it will undertake the investment. If the

interest rate is higher than the rate of return on investment, the firm will not invest. (p.

251)

Samuelson was reflecting upon the works, in the classical theory of capital, of Irving Fisher.

Although the firm has some interest in interest rates, many others are affected by the interest

rates of capital in nations the world over. Furthermore, there has long been a concern regarding

the future uncertainty of interest rates and what that can mean for an aggregate economy

(Jewczyn, 2009, p. 27). It has also been demonstrated that the nature and nurture of international

trade, or how an aggregate economy could have the opportunity to domestically expand beyond

the parameters of the efficient frontier economically, does have some bearing upon the interest

rates, and thus the general trading interest, between two countries (Jewczyn, 2010, p. 75). This

paper discusses some of the aspects of the international Fisher effect by addressing the the

definition of the international Fisher effect; the international Fisher effects existence in practice;

and some empirical tests as well as the researchers hypothesis testing.

The International Fisher Effect Defined

Eiteman, Stonehill, and Moffett (2007) noted the straightforward definition of the effect

as follows: The relationship between the percentage change in the spot exchange rate over time

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Journal of Business Management and Entrepreneurship 2010 • September • Volume: 1 • Issue: 9

and the differential between comparable interest rates in different national capital markets is

known as the international Fisher effect (p. 112). In more common parlance, the international

Fisher effect, more generally known as the Fisher-open, contends that the relationship of

interest rates in two nations is defined by the exchange rates spot price and the prevailing

interest rates of the two nations; the spot rate and the two interest rates move in equal amounts,

but merely in different (opposite) directions (Eiteman et al. 2007, p. 112). One of the conditions

of tabulation, which must be satisfied for the comparison to actually hold true in the

mathematical sense, is that the beginning and the ending period indirect quotes, of the spot

exchange rate, should be used for the computations of that specific spot exchange rate (Eiteman

et al. 2007, p. 112). Another assumption for the use of the tabulations in calculation is that

investors are essentially fully informed, through the results of perfect information in the market

secondary to full transparency of financial intermediaries (FIs). Furthermore, the investors

themselves are completely indifferent to the inherent form of the currency held, so long as there

is the opportunity for profit, barring arbitrage opportunities. This is because all of the markets

imperfections have been competed down to a relative zero position, secondary to the

international unrestricted capital flows (Eiteman et al. 2007, p. 112).

The International Fisher Effects Existence in Practice

it should be common knowledge in academic circles, among historians who follow such

things, that the seminal document published in the attainment of the Ph.D. degree (in the 19th

century) was known conventionally as the thesis, although the contemporary name for the same

document is the dissertation. Fisher ([1892], 2006) first publicly alluded to the Fisher effect in

his doctoral thesis with the blithe allusion that, If the price of (a) increases, [a certain theoretical

commodity, such as an interest rate] OA relatively diminishes and a new point of tangency is

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Journal of Business Management and Entrepreneurship 2010 • September • Volume: 1 • Issue: 9

found (p. 73). Fisher explained the eventual opposite direction of the movement of the

commodity by noting that these commodities (or theoretically, the interest rates of the two

countries in question, for our example of the current Fisher-open) are in actuality inversely

proportional to the beginning and ending theoretically converted (a) and (b), which were

essentially theoretically descriptive delimiters of the beginning and ending spot currency rates

(Fisher, [1892], 2006, p. 73). This line of thought was then expanded, when Fisher ([1912],

2007) realized that the international Fisher effect did not necessarily hold true in the short term,

but that it does hold true in the long run. In other words, prices were not necessarily just the

effects (during the long run), but that pricing (for our example, the spot rates) could actually be

held responsible as the proximal cause in the short term (p. 169).

Empirical Tests and the Researchers Hypothesis Testing

Although some social scientists might contend that the particular type of rose-colored

glasses used by a particular researcher could skew the results (or have the tendency towards a

self-fulfilling prophecy, with regard to the researchers results), it would probably not be too

difficult to assert, from a common-sense viewpoint, that the empirical tests run and

methodologies utilized could account for some of the eventual results hypothesized. An

examination of the literature showed that the complete Fisher-open did not completely hold true

for an examination of raw data from Turkey, for a period covering 1990 to 2003, when the

Johansen cointegration method was used to interpret the relationship between the monthly

interest rate and inflation rate data, with regard to the long-term effect. The unique vector

showing the relationship between inflation and nominal rates was demonstrated as extant (Gul &

Acikalin, 2008, p. 3230).

Other research echoed the fact that the cointegration methods (and integration methods)

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Journal of Business Management and Entrepreneurship 2010 • September • Volume: 1 • Issue: 9

of the variables researched do matter and a Kalman filter was employed. These results confirmed

the Turkish studys results depicted above, with regard to the fact that inflation rates and nominal

interest rates do not respond on an equal point basis. Researchers found, however, that in several

large databases of country-wide data, there was no long-run Fisher effect resulting from the

examination of those raw data (Hatemi-J & Irandoust, 2008, p. 623). Jensen (2009) posited that

researchers were simply asking the wrong questions and were looking in the wrong places. That

is, exogenous shocks to the inflation rates in industrialized economies have not produced the

permanent change to inflation necessary for testing the Fisher effect” (p. 221). Therefore, Jensen

concluded that the Fisher-open could not even be tested. This is because Since a permanent

change to inflation has not occurred, a test of whether a permanent change to inflation affects the

nominal interest rate one-for-one will be uninformative as to the truth or fallacy of the Fisher

effect hypothesis (p. 221).

Kaliva (2008) disagreed with most of the literature with the assertion that, We find

supportive evidence for the Fisher hypothesis that the nominal interest rate and expected

inflation move one-for-one both in the short and the long run (p. 1). Lee (2009) found that, for

the Singapore economic data gathered for the period from 1976 to 2006, using the Johansen

Method for examination, there was evidence of a positive relationship between nominal interest

rate and inflation rate while rejecting the notion of a full Fisher Effect (p. 75).

Conclusion

The relationship between the percentage change in the spot exchange rate over time and

the differential between comparable interest rates in different national capital markets is known

as the international Fisher effect. In more common parlance, the international Fisher effect,

more generally known as the Fisher-open, contends that the relationship of interest rates in two

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Journal of Business Management and Entrepreneurship 2010 • September • Volume: 1 • Issue: 9

nations is related by the exchange rates spot price and the prevailing interest rates of the two

nations; the spot rate and the two interest rates move in equal amounts, but merely in opposite

directions. Irving Fisher first publicly alluded to the Fisher effect in his doctoral dissertation

with the allusion that, if the price of (a) increases, (a certain theoretical commodity, such as an

interest rate) OA relatively diminishes and a new point of tangency is found. An examination of

the literature showed that the complete Fisher-open did not completely hold true for an

examination of raw data from Turkey, for a period covering 1990 to 2003, when the Johansen

cointegration method was used to interpret the relationship between the monthly interest rate and

inflation rate data, with regard to the long-term effect. The unique vector showing the

relationship between inflation and nominal rates was demonstrated as extant as a unique vector.

Jensen posited that researchers were simply asking the wrong questions and looking in the wrong

places because exogenous shocks to the inflation rates in industrialized economies have not

produced the permanent change to inflation necessary for testing the Fisher effect. A logical

conclusion could be, depending upon the data, researchers, and methods utilized, that empirical

tests may or may not confirm that the international Fisher effect exists in practice. More

research is needed in this area of endeavor for a conclusive outcome to be derived.

Eiteman, D. Stonehill, M. & Moffett, M. (2007). Multinational business finance. Boston, MA:

Addison Wesley.

Fisher, I. ([1892], 2006). Mathematical investigations in the theory of value and prices. New

York, NY: Cosimo Classics.

Fisher, I. ([1912], 2007). The purchasing power of money: Its determination and relation to

credit interest and crises. New York, NY: Cosimo Classics.

Gul, E. & Acikalin, S. (2008). An examination of the Fisher hypothesis: The case of Turkey.

Applied Economics, 40(24), 3227-3231. doi: 10.1080/00036840600994112

Hatemi-J, A. & Irandoust, M. (2008). The Fisher effect: A Kalman filter approach to detecting

structural change. Applied Economics Letters, 15(8), 619-624. doi:

10.1080/13504850600721924

Jensen, M. (2009). The long-run Fisher effect: Can it be tested? Journal of Money, Credit &

Banking. 41(1), 221-231. doi: 10.1111/j.1538-4616.2008.00194.x