a) Explain the international Fisher effect (IFE) theory. Explain why the IFE may not hold.

b) Assume that the Australian dollar’s spot rate is $.90 and that the Australian and U.S. one-year interest rates are initially 6 percent. Then assume that the Australian one-year interest rate increases by 5 percentage points, while the U.S. one-year interest rate remains unchanged. Using this information and the international Fisher effect (IFE) theory, forecast the spot rate for one year ahead.

c) According to the IFE, what is the underlying factor that would cause such a change in interest rate in (b) above? If U.S. investors believe in the IFE, will they attempt to capitalize on the higher Australian interest rates? Explain.