Current one-year interest rates are 4% and 8% in Canada and Spain respectively.The anticipated inflation in Canada is 2%.If international Fisher effect holds, what is the expected inflation in Spain?

Question

Quizplus · Accepted Answer

The international Fisher effect states that the difference in interest rates between two countries is equal to the expected change in their exchange rate. So, in this case, the difference in interest rates between Canada and Spain is 8% - 4% = 4%. However, we need to adjust this for inflation.

In Canada, the anticipated inflation is 2%. So the real interest rate in Canada is 4% - 2% = 2%.

Using the international Fisher effect, we can calculate the expected inflation in Spain as follows:

Expected inflation in Spain = (1 + Canadian interest rate)/(1 + Spanish interest rate) - 1 
Expected inflation in Spain = (1 + 0.02)/(1 + 0.08) - 1 
Expected inflation in Spain = 0.0592 or 5.92%

Therefore, the answer is C (5.92%).

Current One-Year Interest Rates Are 4% and 8% in Canada