What is the Fisher effect regarding nominal and real interest rates?

The Fisher Effect is an economic theory that describes the relationship between nominal interest rates, real interest rates, and inflation. It's named after economist Irving Fisher, who introduced the concept. The Fisher Effect helps us understand how changes in inflation impact nominal interest rates and real interest rates. Here's an explanation:

1. Nominal Interest Rate:

• The nominal interest rate is the rate of interest unadjusted for inflation. It's the interest rate you see on loans, savings accounts, or bonds.

2. Real Interest Rate:

• The real interest rate is the nominal interest rate adjusted for inflation. It represents the true return on an investment after accounting for the loss of purchasing power due to inflation.
• Real Interest Rate = Nominal Interest Rate - Inflation Rate

3. Fisher Effect Equation:

• The Fisher Effect can be expressed through the following equation:
• (1 + Nominal Interest Rate) = (1 + Real Interest Rate) * (1 + Inflation Rate)

4. Understanding the Fisher Effect:

• The Fisher Effect states that nominal interest rates will adjust in response to changes in expected inflation.
• When inflation expectations increase, nominal interest rates will also rise to compensate lenders for the expected loss of purchasing power.
• Conversely, if inflation expectations decrease, nominal interest rates will fall.
• The relationship suggests that real interest rates should remain relatively stable over time, reflecting the underlying real return on investment opportunities.

5. Significance of the Fisher Effect:

• Investor Expectations: The Fisher Effect assumes that investors and lenders consider expected inflation when setting or accepting nominal interest rates. It highlights the importance of inflation expectations in financial decision-making.
• Central Banks: Central banks use the Fisher Effect to guide their monetary policy decisions. If they want to combat rising inflation, they may raise nominal interest rates to increase the real interest rate.
• Real Return on Investments: For investors, understanding the Fisher Effect helps assess the real return on investments. If inflation is expected to increase, they may seek investments that offer higher nominal interest rates to maintain or grow their purchasing power.

6. Example:

• Suppose you have a savings account that pays a nominal interest rate of 5%, and the expected inflation rate for the year is 3%.
• Using the Fisher Effect equation, you can calculate the real interest rate:
• (1 + 0.05) = (1 + Real Interest Rate) * (1 + 0.03)
• 1.05 = (1 + Real Interest Rate) * 1.03
• Real Interest Rate = (1.05 / 1.03) - 1 ≈ 1.94%

In this example, the real interest rate on your savings account is approximately 1.94% after accounting for the expected 3% inflation.

In summary, the Fisher Effect explains the relationship between nominal interest rates, real interest rates, and inflation. It helps investors, policymakers, and economists understand how changes in inflation expectations can impact the cost of borrowing and the real return on investments.