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Please Sir help me with these two problems of mine!
1) Is it true that according to Fisher Model assumption if there is an increase in interest rate it will instigate the increase in inflation rate (they move together) and eventually increase in interest & inflation rates will cause the local currency to depreciate more?
2) If there is a depreciation in local currency against the foreign currency the exchange rate will be increasing against Foreign Currency like this:
If Pound is Local Currency against Foreign Currency of $:
Pound 1.50 / $1
After depreciation caused by increase in interest & inflation in Local Currency:
Pound 1.60 / $1
The fisher model looks at the relation between the real and nominal interest rates – essentially if there has been inflation in the economy (think of a rise in general prices), the value of money essentially comes down (think £1 in 2005 vs £1 in 2021)
What then happens is the REAL rate of return for any investment is compromised
If I issued a loan of £100 with an interest rate of 5%. I would need £5 annually as my real return to satisfy the 5% rate.
If there was no inflation in the economy, the £5 satisfies the condition of 5%
However, due to general inflation – the £5 interest received has actually lost value over the past year.
In order to incorporate inflation to find out what we must receive as return, we use the fisher formula:
( 1 + Real Rate ) * ( 1 + Gen. inflation) = (1 + Nominal Rate)
So, in this example if I wanted 5% REAL return, but there was a general inflation rate of 3% in the economy, the nominal rate that I should ask for would be
( 1+ 0.05 ) * (1 + 0.03 )
Therefore, if I were to issue a loan of £100 and wanted a REAL return of 5%, in an economy where the general inflation is 3%, I would ask for the interest at 8.15%, to compensate for the inflationary effect on the currency value.