ACCA Financial Management (F9) Certification Practice Exam

What does the Fisher effect relate to regarding economic variables?

1. Inflation rates and currency exchange rates

2. Interest rates and expected inflation rate

3. Spot rates and forward exchange rates

4. International competitiveness and cash flows

The correct answer is: Interest rates and expected inflation rate

The Fisher effect describes the relationship between nominal interest rates, real interest rates, and the expected inflation rate. Specifically, it states that the nominal interest rate is equal to the sum of the real interest rate and the expected inflation rate. This relationship implies that if the expected inflation rate increases, the nominal interest rate must also increase to maintain the same real interest rate, which reflects the purchasing power of money. Understanding this concept is important because it helps financial managers make informed decisions about investment and financing. For instance, when evaluating the cost of borrowing or the return on investment, the effect of expected inflation on nominal interest rates needs to be considered. This relationship is crucial for assessing the true cost of capital and the real return on investments. The other options, while related to financial concepts, do not accurately capture the essence of the Fisher effect. For instance, while inflation rates and currency exchange rates can influence each other, this relationship is not the core focus of the Fisher effect. Similarly, spot rates and forward exchange rates pertain more to foreign exchange markets, and international competitiveness versus cash flows involves broader economic frameworks that incorporate multiple factors beyond the direct relationship outlined by the Fisher effect.