Assume that the one-year interest rate in the U.S. is 7% and in the U.K. is 5%. According to the international Fisher effect, British pound's spot exchange rate should ____ by about ____ over the year.

Question

Quizplus · Accepted Answer

According to the international Fisher effect, the difference in interest rates between two countries should reflect the expected change in their exchange rate over time. In this case, since the U.S. has a higher interest rate than the U.K., the British pound is expected to appreciate relative to the U.S. dollar. The formula for the expected change in the exchange rate is (1+iU.K.)/(1+iU.S.)-1, which equals (1+0.05)/(1+0.07)-1 = 0.019, or 1.9% appreciation. Therefore, the correct answer is B.

Assume That the One-Year Interest Rate in the U