Friday, 12 July 2013

Fisher Equation and its effect

An economic theory proposed by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.

The Fisher Equation is used in economic theory to explain the relationship between interest rates and inflation. The theories behind it were introduced by American economist Irving Fisher. Fisher was one of the first economists to identify a difference between a real and a nominal interest rate, and his work in this area culminated in this equation.
Expressed mathematically, the Fisher Equation is

real rate of interest + inflation rate = nominal rate of interest.


The Fisher Equation - An Example
The Fisher Effect

Suppose that the nominal interest rate in an economy is 8 percent per year but inflation is 3 percent per year. What this means is that, for every dollar someone has in the bank today, she will have $1.08 next year. However, because stuff got 3 percent more expensive, her $1.08 won't buy 8 percent more stuff the next year, it will only buy her 5 percent more stuff next year. This is why the real interest rate is 5 percent.
This relationship is particularly clear when the nominal rate of interest is the same as the inflation rate- if money in a bank account earns 8 percent per year but prices increase by 8 percent over the course of the year, the money has earned a real return of zero.
In other words, the equation clarifies that the real interest rate for a loan is equivalent to the posted, or nominal, interest rate minus the rate of inflation. The Greek letter π is normally used to signify the inflation rate and should not be confused with the constant that π represents in geometry.
If inflation is taken into account, then it is not the real interest rate that changes, but the nominal interest rate that adjusts or alters with inflation. The inflation rate used when evaluating the equation is generally the expected inflation rate throughout the life of the loan. This being said, the Fisher Equation was hypothesized with the idea that the rate of inflation was constant. Taking into account the rate of inflation places the interest rate of a loan within a realm affected by current business, technology, and other world events that affect the real word economy.
This equation can be implemented either ex-ante, meaning before, or ex-post, meaning after, an analysis of a loan. If the equation is used to evaluate the loan ex-post, for example, it could help to determine the purchasing power of the loan and calculate whether or not the loan was worthwhile. It is also used to help lenders determine what an interest rate should be. By using this equation, lenders can take into consideration any anticipated loss of purchasing power, either on the principal balance or on the interest, and set interest rates favorably.
The Fisher Equation is commonly used while estimating the worth of investments and evaluating the yield of bonds and investments after the fact. It should not be confused withFisher’s Equation, otherwise known as the Fisher-Kolmogorov Equation. Fisher’s Equation is a differential equation dealing with heat and mass transfer within the field of natural sciences, rather than the field of economics.

 'Fisher Effect'

The Fisher Effect
The Fisher Effect

The Fisher effect states that, in response to a change in the money supply, the nominal interest rate changes in tandem with changes in the inflation rate in the long run. For example, if monetary policy were to cause inflation to increase by 5 percentage points, the nominal interest rate in the economy would eventually also increase by 5 percentage points.
In order to understand the Fisher effect, it's crucial to understand the concepts of nominal and real interest rates.

The Fisher effect can be seen each time you go to the bank; the interest rate an investor has on a savings account is really the nominal interest rate. For example, if the nominal interest rate on a savings account is 4% and the expected rate of inflation is 3%, then money in the savings account is really growing at 1%. The smaller the real interest rate the longer it will take for savings deposits to grow substantially when observed from a purchasing power perspective.


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