Fisher Effect - Explained
What is the Fisher Effect?
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Table of ContentsWhat is the Fisher Effect?The Fisher Effect EquationExample of the Fisher Effect TheoryNominal Interest Rates and Real Interest RatesImportance in Money SupplyThe International Fisher Effect (IFE)Academic Research on the Fisher Effect
What is the Fisher Effect?
The Fisher effect, also known as the Fisher Hypothesis, is an economic theory which was proposed by an economist named Irving Fisher. The theory states that the real interest rate is independent of monetary measures, specifically the nominal interest rate and the expected inflation rate. It describes the underlying relationship between inflation and both real and nominal interest rates. The theory proposes that the difference between the nominal interest rate and the expected inflation rate is equal to the real interest rate. Consequently, a rise in inflation leads to a fall in real interest rates, unless the same rate of increment occurs in nominal rates as with inflation. Mathematically, Real Interest Rate = Nominal Interest Rate - Inflation Rate.
- The Fisher Effect is an economic theory that was created by Irving Fisher between 1867-1947.
- The theory states that the real interest rate is independent of monetary measures, specifically the nominal interest rate and the expected inflation rate.
- It also states that the real interest rate equals the subtraction of the nominal interest rate from the expected inflation rate.
- In the Fisher Effect equation, all rates provided are seen as a composite.
- The Fisher Effect has been extended to the analysis of the money supply and the trading of international currencies.
- The Fisher Effect claims that all changes in inflation must be mirrored in the nominal interest rate if the real interest rate isn't affected.
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The Fisher Effect Equation
In the Fisher Effect equation, all rates provided are seen as a composite, i.e., they are seen as a whole and not as individual elements. The equation shows how to get the real interest rate by the subtraction of the expected inflation rate from the nominal interest rate. It also assumes that the real rate is constant making the nominal rate change point-for-point when there is a rise or fall in the inflation rate. The implication of the assumed constant real rate is that monetary events such as monetary policy actions will have no effect on the real economy.
Example of the Fisher Effect Theory
A real-world example of this theory can be seen in the banking industry. The nominal interest rate an investor has on a savings account is actually his nominal interest rate. If for instance, the nominal interest rate of an investor's savings account is 5% and its expected inflation rate is 4%, then the money in his account is actually growing at 1%. This implies that the rate of growth of his savings deposits depends on the real interest rate when observed from the perspective of his purchasing power. The lower the real interest rate, the longer it will take for his deposits to grow and vice versa.
Nominal Interest Rates and Real Interest Rates
Nominal interest rates state the monetary return that an investor's deposit will earn in a bank. An example, is a 6% increase in his deposit the next year if the nominal interest rate of the deposit is 6% per year assuming he made no withdrawals the previous year. Real interest rates on the other hand, considers his purchasing power. Using the example above, by the following year, the money in the bank will be able to buy 6% more commodities than if it was withdrawn and spent the previous year. The only connection between the real and nominal interest rates is the inflation rate which changes the quantity of commodity that can be bought by a given amount of money.
Importance in Money Supply
The Fisher Effect appears to be more than just an equation. The tandem effect of the money supply on the interest rate and inflation rate is shown by the Fisher Effect. For instance, if there is a push in a country's inflation rate by a 10% rise, caused by a change in its central bank's monetary policy, there will also be a 10% increase in the nominal interest rate of its economy. In this view, there is an assumption that the real interest rate will not be affected by a change in money supply. Nevertheless, the changes in the nominal interest rate will be directly shown.
The International Fisher Effect (IFE)
The international Fisher effect, which is also referred to as "Fisher's open hypothesis" is a hypothesis in international finance that suggests differences in nominal interest rates showing expected changes in the spot exchange rate between countries. It is specifically stated by the hypothesis that a spot exchange rate is expected to change equally in the opposite direction of the interest rate differential. Hence, the currency of the country which posses the higher nominal interest rate is expected to depreciate against the currency of the country that possesses the lower nominal interest rate. This is because higher nominal interest rates show an expectation of inflation.