The Fisher Effect, developed by Irving Fisher, explains the link between interest rates and inflation rates within a given country. According to Aina, this relationship contradicts classical monetary theory, which states that interest rates are independent of price level.

The fisher effect states that the nominal interest rate is comprised of two components: the real interest rate and the expected inflation rate. Numerically, we state this at 1+r=(1+a)(1+i), or r=a+i+ai. For simplicity’s sake, the hypothesis is most often estimated using the basic equation r=a+i. This hypothesis can also be explained in terms of the real interest rate, where the real interest rate equals the nominal interest rate minus the expected inflation rate. When we look at the equation this way, it can be used to explain the real return a consumer expects to gain as a result of their investments (Shapiro, 2009, p. 103)

The significance of this hypothesis is that it shows how an increase in inflation rates in a country will result in increased nominal interest rates, and vice versa, in a one-to-one ratio. To put this theory into practice, suppose a bank charges a nominal interest rate of 7.00% on a CD. If the inflation rate in the country is 2.00%, then the real interest rate to the investor would only be 5.00%. If the inflation rate increases to 4.00%, the bank will still require a constant real return of 5.00%, therefore raising the nominal interest rate they charge to 9.00%. Fisher argued that as long as borrowers and lenders agree on a real interest rate, they could therefore affect future of inflation (Aina, n.d.)

In regards to international finance, Fisher states that these changes in real interest rates are equalized, like exchange rates, through arbitrage. Countries with lower inflation rates, and therefore nominal interest rates, will also draw in more capital, in turn raising these rates. Arbitrage will continue to occur as long as there is no government interference. 

References:
Aina, Victor O. “Fisher’s Hypothesis: A Continuous-Time Generalization.” Simon Fraser University: Department of Economics. n.d. <http://www.sfu.ca/~aina/ fisher.pdf>.