Current 1-year interest rates are 4% and 8% in the United States and Spain,respectively.The anticipated inflation in the United States is 2%.If International Fisher effect holds,what is the expected inflation in Spain?

Question

Quizplus · Accepted Answer

According to the International Fisher effect, the difference in interest rates between two countries reflects the expected change in their exchange rates. Therefore, the expected change in the exchange rate between the US and Spain can be calculated as follows:

Expected change in exchange rate = US interest rate - Spain interest rate 
= 4% - 8% = -4%

Since the anticipated inflation rate in the US is 2%, the expected inflation rate in Spain can be calculated as follows:

Expected inflation rate in Spain = Expected change in exchange rate + Anticipated inflation rate in the US 
= -4% + 2% 
= -2%

However, inflation rates cannot be negative, so we need to take the absolute value of the expected inflation rate:

Expected inflation rate in Spain = | -2% | 
= 2%

Finally, we need to add the anticipated inflation rate in Spain to this calculated value:

Expected inflation rate in Spain = Anticipated inflation rate in Spain + 2% 
8% = Anticipated inflation rate in Spain + 2% 
Anticipated inflation rate in Spain = 6%

Therefore, the expected inflation rate in Spain is 6%, which corresponds to choice C.

Current 1-Year Interest Rates Are 4% and 8% in the United