What is the Fisher Effect?
How does it work in economics?
What are the essential elements you should know!
In this article, we will break down the notion of “Fisher Effect” so you know all there is to know about it!
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Table of Contents
What Is The Fisher Effect
The Fisher Effect is an economic theory defined by Irving Fisher, an economist, who explained the relationship between real interest rate, nominal interest rate, and inflation.
This relationship was explained by Fisher in the 1930s during the Great Depression.
The “Fisher Effect” concept is quite simple to explain.
If you have an investment earning you 5% in interest (nominal interest rate) and the inflation is 3% (inflation), you can expect your investment to actually grow by 2% (real interest rate).
What you see in your investment account is “nominal” interest, it’s what you actually see.
The real rate of interest is what you are truly earning in light of the “inflation” as an economic factor impacting your purchasing power.
This economic theory is used in making decisions about money supply by the government or the central banks.
By understanding the relationship between inflation, nominal interest rate, and real interest rate, the central bank can adopt monetary policy in such a way that they could adjust nominal interest rate according to the inflationary impact the policy may have.
If a monetary policy triggers a 5% rise in inflation, the central bank would know how to manipulate the nominal interest rate to control the real rate of interest.
Fisher Effect Definition
The “Fisher” effect is an economic theory named after the economist Irving Fisher who was able to explain the relationship between nominal rate of interest, inflation, and the real rate of interest.
The Fisher Effect can be presented in an economic formula:
Nominal Interest Rate – Expected Inflation = Real Interest Rate
Fisher Effect Applications
Since Fisher described the relationship between real interest rate and nominal interest rate, the concept has been used in different disciplines.
Let’s look at a few Fisher Effect examples and applications.
Central banks use the economic theory of Fisher to control inflation and maintain it within a healthy range.
One of the central bank’s roles in any country is to ensure that there’s a little bit of inflation to avoid a deflation spiral but not too much inflation to avoid overheating the economy.
To prevent inflation from spiraling upwards or deflation, the central bank sets the nominal interest rate in the economy by changing the reserve ratios, making open market operations, or other activities.
To assess portfolio and investment returns, it’s important to understand the nuances between nominal interest and real interest to better understand the true returns offered by an investment over time.
If you are able to invest your money and get a 10% nominal interest, you may appear happy.
However, if during the same period of time, there was a 15% inflation, you will realize that you actually lost 5% purchasing power.
As a result, the Fisher equation is used to determine the proper nominal interest rate of return required by an investment to ensure that the investor actually generates a “real” return over time.
In the currency markets, the Fisher Effect is actually called the International Fisher Effect.
This economic theory is used to predict the spot exchange rate for the currency of different countries in light of the differences in each of the country’s nominal interest rates.
Based on the nominal interest rate in two different countries and the spot exchange rate in the market as of a given day, you can calculate the future spot rate.
International Fisher Effect
The Fisher Effect is used in different ways and has different applications.
In the context of Forex trading and analysis, the Fisher Effect is used to predict the present and future spot currency price movements.
This is called the International Fisher Effect or IFE.
Based on the IFE, the expected disparity between the exchange rate of two currencies is equal to the difference in the two countries’ nominal interest rate.
In this application, the present and future risk-free nominal interest rates are used to forecast currency price movements.
Fisher Effect Formula
The Fisher Effect formula is: Nominal Interest Rate – Expected Inflation = Real Interest Rate.
Here is the actual formula:
(1+i) = (1+r) * (1+π)
i = Nominal Interest Rate
r = Real Interest Rate
π = Expected Inflation Rate
In the Fisher Effect equation, the real interest rate goes down as inflation increases keeping the nominal interest rate constant.
Nominal Interest Rate
Nominal interest rate is what you (or an investor) will see in return if you deposit your money at the bank.
For example, if you deposit your money in a savings account earning you 2%, you are getting a 2% nominal interest.
In fact, your $1,000 will become $1,020 where you have received $20 in nominal return representing 2% of your initial deposit.
Inflation represents the decline of your purchasing power over time.
In any given economy, when the cost of living goes up, it is due to inflationary pressures resulting in the same basket of goods costing more over time.
For example, if your living expenses cost you $2,000 per month and the following year it costs $2,200 per month (for the exact same things), then you need to spend $200 more to buy the same things.
In essence, your purchasing power has declined.
Real Interest Rate
Real interest rate is a rate of interest that considers the impact of inflation on your returns.
For example, if you put your money in the bank earning you 10% return, you are getting a nominal interest of 10%.
However, if at the same time, there was an inflation rate of 4%, your purchasing power declines by that amount.
As a result, your “real” interest rate (considering your purchasing power) is 6%.
Limitations of The Fisher Effect
One limitation of the Fisher Effect may be due to the elasticity of demand with regards to interest rates.
In periods of high consumer confidence and rising asset prices, a high real interest rate may not have any meaningful effect on reducing demand.
Another important limitation of the Fisher Effect has to do with “liquidity traps”.
Liquidity traps occur when the saving rates are high and the interest rates are low.
In a liquidity trap, reducing nominal interest rates may have no impact on increasing consumer spending as lower interest rates do not encourage investment and spending.
Fisher Effect Takeaways
So, what is the Fisher Effect?
Why is this economic theory important?
Let’s look at a summary of our findings.
The Fisher Effect
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