Lesson 17 of 20
Economist Irving Fisher is credited with the inflation expectations theory of interest rates, which proposes that the nominal risk free interest rate (i.e., developed economy government issued debt) consists of a real interest rate plus and an inflation expectation.
1 + r f nominal = (1 + r f real)(1 + E(I))
The International Fisher Relation connects the difference in nominal risk free interest rates between countries to their expected inflation rates.
(1+ r f X)/( 1+ r f Y) = ((1 + E(IX)/(1 + E(IY))
A flaw in the international Fisher relation is that the model does not take business cycle differences between economies into consideration.