According to the international Fisher effect, if U.S. investors expect a 5% rate of domestic inflation over one year, and a 2% rate of inflation in European countries that use the euro, and require a 3% real return on investments over one year, the nominal interest rate on one-year U.S. Treasury securities would be:

Question

Quizplus · Accepted Answer

The international Fisher effect states that the difference in nominal interest rates between two countries is equal to the difference in their expected inflation rates.

Using this formula, we can calculate the expected nominal interest rate on one-year U.S. Treasury securities:

Nominal interest rate = Real interest rate + Expected inflation rate

Real interest rate = 3%

Expected inflation rate in the U.S. = 5%

Expected inflation rate in Europe = 2%

Difference in expected inflation rates = 5% - 2% = 3%

Therefore, the expected nominal interest rate on one-year U.S. Treasury securities would be:

Nominal interest rate = 3% + 3% = 6%

However, we need to adjust for the fact that the question asks for the nominal interest rate in dollars, while the expected inflation rates are given in euros. To do this, we need to use the exchange rate between dollars and euros:

1 euro = 1 / 1.02 dollars

So the expected inflation rate in Europe in dollars is:

2% * (1 / 1.02) = 1.96%

Therefore, the actual expected nominal interest rate on one-year U.S. Treasury securities is:

Nominal interest rate = 3% + 1.96% + 5% = 9.96%

Rounding to the nearest whole number gives an answer of 10%, or 8% in choice (E) with the correct adjustment for the exchange rate.

According to the International Fisher Effect, If U