# How does the Fisher Effect relate to nominal and real interest rates?

Examine the relationship between the Fisher Effect and nominal and real interest rates, and learn how it helps distinguish between the impact of inflation and actual interest rate changes.

The Fisher Effect is a concept that relates nominal interest rates, real interest rates, and expected inflation. It describes the relationship between these three variables and is important for understanding the impact of inflation on the returns earned from investments or the cost of borrowing. Here's how the Fisher Effect relates to nominal and real interest rates:

**Nominal Interest Rate**: The nominal interest rate is the stated interest rate on a financial instrument, such as a loan or a bond. It represents the actual interest payment made or received, usually expressed as a percentage of the principal amount. For example, if you have a savings account that pays 5% interest per year, that is the nominal interest rate.**Real Interest Rate**: The real interest rate is the interest rate adjusted for inflation. It reflects the true purchasing power of the interest earned or paid on an investment after accounting for changes in the general price level. The real interest rate is calculated as follows:Real Interest Rate = Nominal Interest Rate - Expected Inflation Rate

In this equation, the real interest rate tells you how much your purchasing power will increase or decrease when you invest or borrow at the given nominal interest rate and considering the expected rate of inflation.

**Expected Inflation Rate**: This is the rate at which prices are expected to rise in the future. It represents the erosion of purchasing power due to rising prices. Expected inflation can vary and is influenced by economic factors, central bank policies, and market expectations.

Now, let's see how the Fisher Effect relates these variables:

The Fisher Effect posits that nominal interest rates adjust to changes in expected inflation. Specifically, it suggests that if expected inflation increases, nominal interest rates will also increase, assuming the real interest rate remains constant. Conversely, if expected inflation decreases, nominal interest rates will decrease.

The rationale behind this relationship is that lenders and borrowers want to maintain their real return on investment or borrowing. If they expect prices to rise (inflation), they will demand a higher nominal interest rate to compensate for the anticipated loss of purchasing power.

The Fisher Effect emphasizes the importance of considering inflation when evaluating the true value of an investment or the cost of borrowing. It helps investors and borrowers understand how their returns or expenses will be affected by inflation expectations.

In summary, the Fisher Effect describes how nominal interest rates, real interest rates, and expected inflation are interrelated. It underscores that nominal interest rates should reflect both the real return on investment and the expected erosion of purchasing power due to inflation. Understanding this relationship is essential for making informed financial decisions and assessing the true impact of interest rates in an inflationary environment.

## Relating the Fisher Effect to Nominal and Real Interest Rates.

The Fisher effect is a theory that describes the relationship between nominal interest rates, real interest rates, and expected inflation rates. It states that the nominal interest rate is approximately equal to the sum of the real interest rate and the expected inflation rate. This can be expressed mathematically as:

```
Nominal Interest Rate ≈ Real Interest Rate + Expected Inflation
```

**Nominal Interest Rate:** The nominal interest rate is the rate of interest that is stated on a loan or investment. It is the rate that borrowers pay to lenders and the rate that lenders earn on their investments.

**Real Interest Rate:** The real interest rate is the nominal interest rate adjusted for inflation. It is the rate of return that lenders earn on their investments after taking into account the expected loss of purchasing power due to inflation.

**Expected Inflation:** Expected inflation is the rate at which people expect prices to rise in the future. It is based on people's expectations about economic conditions and government policy.

The Fisher effect is based on the assumption that investors are rational and forward-looking. This means that they will take into account expected inflation when making decisions about their investments. If investors expect inflation to be high, they will demand a higher nominal interest rate to compensate for the expected loss of purchasing power.

For example, if the nominal interest rate is 5% and the expected inflation rate is 2%, then the real interest rate is approximately 3%. This means that lenders will earn a real return of 3% on their investments after adjusting for inflation.

The Fisher effect has several implications for economic policy. For example, it suggests that central banks can use monetary policy to influence the real interest rate by adjusting the nominal interest rate. Central banks can also use monetary policy to influence inflation expectations. By doing so, they can indirectly affect the real interest rate.

However, it is important to note that the Fisher effect is not always perfect. There may be other factors that affect nominal interest rates, such as economic growth and risk premiums. Additionally, the Fisher effect breaks down when nominal interest rates are at the zero lower bound (ZLB). The ZLB is the point at which nominal interest rates cannot be lowered any further. This is because borrowers would simply prefer to hold cash rather than borrow at a negative interest rate.

Overall, the Fisher effect is a useful tool for understanding the relationship between nominal interest rates, real interest rates, and expected inflation rates. It has important implications for economic policy and can be used to analyze economic trends.