Fisher Effect

Nominal interest rates represent financial returns that a person receives when they deposit money. A nominal interest rate of 5% per year, for example, suggests that an individual will get an extra 5% of his money that he has in the bank. In contrast to the nominal rate, the real rate takes buying power into account.

The nominal interest rate in the Fisher Effect is the given actual interest rate that indicates the growth of money over time to a certain quantity of money or currency due to a financial lender. The real interest rate is the amount that reflects the borrowing money's buying power over time. Nominal interest rates are determined by borrowers and lenders as the sum of their predicted interest rate and projected inflation.

The International Fisher Effect

The International Fisher Effect (IFE) is a concept based on current and projected nominal interest rates to forecast current and future currency price fluctuations.

Fig 1. - Irving Fisher (right)

The International Fisher Effect was developed in the 1930s by Irving Fisher. Irving Fisher is seen in Figure 1 above (right) with his younger son (left). The IFE theory that he created is seen as a better alternative rather than pure inflation and is often used to forecast current and future currency price fluctuations.

This concept assumes that nations with low interest rates will also have low rates of inflation, which might lead to gains in the actual worth of the related currency as compared to other countries, and countries with higher interest rates will more likely see the value of their currency go down.

Fisher Effect formula

The Fisher equation is an economic concept that defines the connection between nominal interest rates and real interest rates when inflation is included. According to the equation, the nominal interest rate equals the real interest rate and inflation added together.

The Fisher equation is usually utilized when investors or lenders request an extra pay to compensate for purchasing power losses due to rising inflation.

The main equation used is:

\((1+i) = (1+r)(1+\pi)\)

The simple version that can also be used is:

\(i \approx r+\pi\)

In both versions:

\(i\) - nominal interest rate

\(r\) - real interest rate

\(\pi\) - inflation rate

Fisher Effect Example

To gain a better understanding, let's go through an example together.

Importance of the Fisher Effect

The importance of the Fisher effect is that it is an essential tool for lenders to use in determining whether or not they're earning money on a loan. A lender will not benefit from interest except when the rate of interest charged is higher than the rate of inflation in the economy. Furthermore, as per Fisher's theory, even if a loan is made without interest, the lending party must at the very least charge the same amount as the inflation rate is in order to preserve buying power upon repayment.

The Fisher Effect also explains how the money supply effects both the inflation rate and the nominal interest rate. For example, if monetary policy is changed in such a way that the inflation rate rises by 5%, the nominal interest rate rises by the same amount. While changes in the money supply have no effect on the actual interest rate, fluctuations within the nominal interest rate are related to changes in the money supply.

Fig 2. - The Fisher Effect

In Figure 2 above, D and S refer to Demand and Supply for loanable funds respectively. When the predicted future inflation rate is 0%, the demand and supply curves for lendable money are D₀ and S₀. Projected future inflation raises demand and supply by 1% for every % rise in expected future inflation. When the predicted future inflation rate is 10%, the demand and supply for loanable funds are D₁₀ and S₁₀. The 10% jump as shown in the figure above brings up the equilibrium rate from 5% to 15%.

As far as borrowers are concerned, let's go through an example using Figure 2 above. If the expected inflation rate were to really jump by 10% as is shown above, the demand would jump as well. This is the shift from D₀ to D₁₀. What does that mean for borrowers? Well, it means that they're prepared to borrow as much now with the rate at 15% as they were at 5%. But why? This is where real vs nominal rates come in. If the inflation rate were to jump 10%, then that means that whoever is borrowing at a rate of 15% is still paying a real interest rate of 5%!

Applications of the Fisher Effect

Since Fisher identified the link between the real and nominal interest rates, the notion has been used in a variety of areas. Let's look at the important applications of the Fisher Effect.

Fisher Effect: Monetary Policy

Fisher's economic theory importance results in it being used by central banks to manage inflation and keep it within a reasonable range. One of the central banks' tasks in every country is to guarantee that there is enough inflation to avert a deflationary cycle but not that much inflation to overheat the economy.

To prevent inflation or deflation from spinning out of control, the central bank may set the nominal interest rate by altering reserve ratios, conducting open market operations, or engaging in other activities.

Fisher Effect: Currency Markets

The Fisher Effect is known as the International Fisher Effect in its application in currency markets.

This important theory is often used to forecast the current exchange rate for various nations' currencies based on variances in nominal interest rates. The future exchange rate may be calculated using the nominal interest rate in two separate nations and the market exchange rate on a given day.

Fisher Effect: Portfolio Returns

To better appreciate the underlying returns produced by an investment over time, it's necessary to grasp the differences between nominal interest and real interest.

You may get excited if you're able to invest your cash and get a nominal interest rate of 15%. However, if there is a 20% inflation within the same time period, you will notice that you have lost 5% buying power.

Consequently, the Fisher equation's application is that it is used to calculate the appropriate nominal interest return on capital required by an investment in order to assure that the investor earns a "real" return over time.

Limitations of the Fisher Effect

One key disadvantage of the Fisher Effect is that when liquidity traps arise, decreasing nominal interest rates might not be enough to promote spending and investment.

Another difficulty is the elasticity of demand in relation to interest rates–when commodities are rising in value and consumer confidence is strong, having higher real interest rates would not necessarily reduce demand, thus central banks would have to raise the real interest rate even more to achieve this.

Finally, the interest rates used by banks may differ from the base rate set by central banks.