Inflation - The Fisher Effect
What Is the Fisher Effect?
The Fisher Effect states that a rise in the nominal interest rate is due to an equal rise in the real interest rate and a rise in expected inflation. The theory was developed by Irving Fisher and suggests that when there is high inflation, the nominal interest rate will increase more than the real interest rate. This can be explained by the fact that lenders would require a higher return on their investments to compensate for any potential decrease in purchasing power over time due to inflation. In other words, a higher nominal interest rate is needed to ensure lenders still receive their desired return after accounting for inflation.
What is the nominal interest rate ?
The nominal interest rate is the rate of interest that is stated by a lender on a loan or deposit. It does not take into account any associated fees, taxes, or adjustments for inflation. This means that the actual return to the borrower can differ from what is advertised due to additional factors and conditions imposed by the lender. For instance, if there are extra fees for late payments or charges for defaulting, then the actual return may be lower than expected.
Nominal Interest Rates and Real Interest Rates
The difference between nominal and real interest rates lies in the fact that a nominal rate is expressed as a percentage and does not take into account any associated fees, taxes, or adjustments for inflation. On the other hand, the real interest rate accounts for factors such as inflation and other associated costs. In general, the nominal interest rate is higher than the real interest rate due to potential decreases in purchasing power over time due to inflation. The gap between these two rates is known as the “inflation premium”, where borrowers are rewarded for taking on additional risk by providing lenders with extra protection from inflationary losses.
How Do You Find the Real Interest Rate?
The real interest rate is the rate of return which takes into account the effects of inflation. It can be calculated by subtracting the current inflation rate from nominal interest rate (the stated or advertised rate). For example, if a loan has a stated interest rate of 8%, and the current inflation rate is 4%, then the real interest rate is 4%. The real interest rate allows investors to compare different opportunities in terms of their return on investment in “real” terms, i.e., taking into account any changes in purchasing power due to inflation.
Fischer effect related to Money Supply
The Fisher effect is an economic theory that describes the relationship between money supply and nominal interest rates. The effect states that an increase in the money supply will lead to a decrease in nominal interest rates, and vice versa. This phenomenon is due to the presence of inflationary forces, where more money in circulation increases demand for goods and services, thus pushing prices up (inflation). As prices increase, lenders are then motivated to lower their lending rate in order to attract more borrowers. The Fisher effect is an important concept within monetary policy as it allows central banks and governments to adjust the money supply in order to affect the level of lending activity.
International Fisher Effect
The International Fisher Effect (IFE) is an economic theory that explains how interest rates in different countries are affected by exchange rate movements. The IFE states that a change in the spot exchange rate between two countries will result in a change in their respective nominal interest rates. This phenomenon is attributed to an increase or decrease in the expected future spot exchange rate, which causes investors to seek higher or lower yields when converting foreign currencies. As such, the IFE is closely tied to developments in international capital markets and investment strategies. Additionally, the IFE helps to explain why certain countries may have higher or lower interest rates than others, even when adjusting for macroeconomic factors such as inflation and growth prospects.
