Question

Assuming the interest rate offered on pounds is 5% and the pound is expected to depreciate by 1.5%, for the international fisher effect to hold between the UK and US, the interest rate should be:

a) 3.5%
b) 4.5%
c) 5.5%
d) 6.5%

Answer 1

For the International Fisher Effect to hold with a 5% interest rate on pounds and an expected pound depreciation of 1.5%, the U.S. interest rate should be 6.5%.

Step-by-step explanation:

To determine the U.S. interest rate for the International Fisher Effect (IFE) to hold between the UK and the U.S., given a 5% interest rate on pounds and an expected depreciation of 1.5%, we use the formula of the IFE: expected inflation rate differential = interest rate differential. Here, the expected inflation differential is the expected depreciation of the pound, which is -1.5%. To find the U.S. interest rate, we subtract this depreciation from the UK interest rate:

U.S. interest rate = UK interest rate - expected currency depreciation

U.S. interest rate = 5% - (-1.5%)

U.S. interest rate = 5% + 1.5%

U.S. interest rate = 6.5%

Therefore, the correct answer is (d) 6.5%.