This article is about what is the Fisher effect. If you are interested in economics, you may have heard of the Fisher Effect, a theory that describes the relationship between inflation and interest rates. The Fisher Effect is a useful concept to understand how inflation and interest rates are related and how they affect the economy and your finances.
What is the Fisher Effect?
But what exactly is the Fisher Effect and why is it important? In this blog post, we will explain the Fisher Effect in simple terms and show how it affects the economy and your finances.
The Fisher Effect is named after Irving Fisher, an American economist who proposed it in 1930. Fisher argued that the real interest rate, which is the interest rate adjusted for inflation, is independent of monetary policy and determined by market forces. Therefore, the nominal interest rate, which is the interest rate that you see on your bank account or loan contract, will change to reflect the expected inflation rate. In other words, if inflation goes up, the nominal interest rate will also go up to maintain the same real interest rate.
Illustration of the Fisher Effect with an Example
To illustrate this, let's use an example. Suppose you have $100 in your savings account that earns 5% interest per year. This means that after one year, you will have $105 in your account. This is the nominal interest rate. However, if the inflation rate is 3% per year, this means that the prices of goods and services will increase by 3% on average. This means that your $105 will have less purchasing power than before. To measure how much your money has grown in real terms, you need to subtract the inflation rate from the nominal interest rate. This is the real interest rate. In this case, the real interest rate is 5% - 3% = 2%. This means that your money has grown by 2% in terms of its ability to buy goods and services.
The Fisher Effect can be expressed by a simple equation:
real interest rate = nominal interest rate - expected inflation rate
This equation is an approximation that works well when both the interest rate and the inflation rate are low. If they are high, a more accurate equation is:
(1 + real interest rate) = (1 + nominal interest rate) / (1 + expected inflation rate)
How Does it Affect the Economy?
The Fisher Effect has important implications for both borrowers and lenders. For borrowers, it means that they have to pay more interest when inflation is high, even if the real interest rate remains constant. For lenders, it means that they have to charge more interest when inflation is high, otherwise they will lose money in real terms. The Fisher Effect also affects the money supply and the exchange rates between different countries.
The Fisher Effect is based on some assumptions that may not always hold true in reality. For example, it assumes that people have rational expectations about future inflation and that they adjust their behavior accordingly. It also assumes that the real interest rate is constant and unaffected by monetary policy or other factors. Some alternative models suggest that changes in expected inflation may affect the real interest rate and the real output of the economy.
Bottom Line
In this article, we have discussed what is the Fisher effect. It is important to keep an eye on both the nominal and the real interest rates and how they change over time.
