What concept suggests that interest rate differentials between two currencies reflect expected changes in their exchange rates?

The concept that interest rate differentials between two currencies reflect expected changes in their exchange rates is known as the International Fisher Effect. This theory posits that the difference in nominal interest rates between two countries is equal to the expected change in their exchange rates. Essentially, if one country has a higher interest rate compared to another, it indicates that its currency is anticipated to depreciate in the future, as investors demand compensation for the expected loss in exchange rate value.

This relationship is grounded in the idea that capital will flow to countries with higher returns, which in turn will influence the value of the currencies involved. Therefore, if investors see a higher interest rate in one nation, they may expect inflation to rise there, leading to a weaker currency over time. The International Fisher Effect helps explain movements in exchange rates based on interest rate differentials, making it a vital concept for understanding international financial markets and currency behavior.

In contrast, other options like the Big Mac Index, GNI Index, and Currency Hedging Effect address different aspects of economics and finance that do not directly relate the interest rate differential to exchange rate changes in the same manner as the International Fisher Effect. For example, the Big Mac Index uses the price of a Big Mac to assess whether currencies are at