Final answer:
The international Fisher effect states that differences in interest rates between two countries foreshadow expected changes in their exchange rates, which affects investment flows and currency values.
Step-by-step explanation:
The international Fisher effect posits that the interest rate differentials between two countries are indicative of the expected change in their exchange rates. Essentially, if the interest rates are higher in one country compared to another, investors are likely to pursue higher returns by investing in that country, which increases demand for that country's currency and causes it to appreciate.
Conversely, if a country's interest rates are lower, its currency tends to depreciate as investors look elsewhere for higher yields. Central banks can impact these interest rates and consequently the exchange rates through monetary policy.
An example is when interest rates rise in the United States relative to Mexico; investors seek the higher returns available in U.S. assets, thus increasing demand for U.S. dollars. This demand shifts the exchange rate until a new equilibrium is reached.
The appreciation of the U.S. dollar against the Mexican peso in this scenario is consistent with the international Fisher effect. Surprise shifts in currency exchange rates often occur due to investor expectations about the future strength or weakness of a currency. Such expectations can be self-reinforcing and lead to substantial short-term fluctuations in exchange rates.