You observe that the inflation rate in the United States is 1.8 percent per year

Question

You observe that the inflation rate in the United States is 1.8 percent per year and that T-bills currently yield 2.3 percent annually. Use the approximate international Fisher effect to answer the following questions. a. What do you estimate the inflation rate to be in Australia, if short-term Australian government securities yield 3 percent per year? (Enter your answer as a percent rounded to 1 decimal place, e.g., 32.1.) Inflation rate % b. What do you estimate the inflation rate to be in Canada, if short-term Canadian government securities yield 6 percent per year? (Enter your answer as a percent rounded to 1 decimal place, e.g., 32.1.) Inflation rate % c. What do you estimate the inflation rate to be in Taiwan, if short-term Taiwanese government securities yield 8 percent per year? (Enter your answer as a percent rounded to 1 decimal place, e.g., 32.1.) Inflation rate %

Explanation / Answer

Answer:

According to the theory of International Fisher Effect real rate of return between two countries remains same & nominal interest rate changes according to changes in inflation rates of that particular country. We can put this theory in below noted formula.

In simple formula = Nominal interest rate = Real rate of return + inflation rate

In exact formula as per International Fisher Effect = (1 + Nominal interest rate) = ( 1 + real rate of interest) x (1 + inflation rate)

Now we know that real rate of return of two countries remain same, so with the help of data given for US, we will find out real rate of return using simple formula(alternatively we can use exact formula of international fisher effect also)

Nominal rate of return in USA = Risk free rate of T bill = 2.3%

Inflation rate in USA = 1.8%

So, Nominal interest rate = Real rate of return + inflation rate

Real rate of return = Nominal interest rate - inflation rate

Real rate of return = 2.3% - 1.8%

Real rate of return = 0.5%

Answer (a):

Now we have real rate of return = 0.5%, with the help of this we will calculate inflation rate of Australia because real rate of return will be the same in Australia also as per international fisher effect

Nominal interest rate in Australia = T bill risk free rate = 3%

Nominal interest rate = Real rate of return + inflation rate

= Nominal interest rate - Real rate of return = inflation rate

3% - 0.5% = inflation rate

2.5% = inflation rate in Australia

Answer (b):

Now we have real rate of return = 0.5%, with the help of this we will calculate inflation rate of Canada because real rate of return will be the same in Canada also as per international fisher effect

Nominal interest rate in Canada = T bill risk free rate = 6%

Nominal interest rate = Real rate of return + inflation rate

= Nominal interest rate - Real rate of return = inflation rate

6% - 0.5% = inflation rate

5.5% = inflation rate in Canada

Answer (c):

Now we have real rate of return = 0.5%, with the help of this we will calculate inflation rate of Taiwan because real rate of return will be the same in Taiwan also as per international fisher effect

Nominal interest rate in Taiwan = T bill risk free rate = 8%

Nominal interest rate = Real rate of return + inflation rate

= Nominal interest rate - Real rate of return = inflation rate

8% - 0.5% = inflation rate

7.5% = inflation rate in Taiwan

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