Fisher Effect Definition and Relationship to Inflation

What Is the Fisher Effect?

The Fisher Effect is an economic theory created 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.

Understanding the Fisher Effect

Fisher's equation reflects that the real interest rate can be taken by subtracting the expected inflation rate from the nominal interest rate. In this equation, all the provided rates are compounded.

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 the 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.

Nominal Interest Rates and Real Interest Rates

Nominal interest rates reflect the financial return an individual gets when they deposit money. For example, a nominal interest rate of 10% per year means that an individual will receive an additional 10% of their deposited money in the bank.

Unlike the nominal interest rate, the real interest rate considers purchasing power in the equation.

In the Fisher Effect, the nominal interest rate is the provided actual interest rate that reflects the monetary growth padded over time to a particular amount of money or currency owed to a financial lender. Real interest rate is the amount that mirrors the purchasing power of the borrowed money as it grows over time.

Importance in Money Supply

The Fisher Effect is more than just an equation: It shows how the money supply affects the nominal interest rate and inflation rate in tandem. For example, if a change in a central bank's monetary policy would push the country's inflation rate to rise by 10 percentage points, then the nominal interest rate of the same economy would follow suit and increase by 10 percentage points as well.

In this light, it may be assumed that a change in the money supply will not affect the real interest rate as the real interest rate is the result of inflation and the nominal rate. It will, however, directly reflect changes in the nominal interest rate.

The International Fisher Effect (IFE)

The International Fisher Effect (IFE) is an exchange-rate model that extends the standard Fisher Effect and is used in forex trading and analysis. It is based on present and future risk-free nominal interest rates rather than pure inflation, and it is used to predict and understand the present and future spot currency price movements. For this model to work in its purest form, it is assumed that the risk-free aspects of capital must be allowed to free float between nations that comprise a particular currency pair.

The IFE was primarily used in periods of monetary policy where interest rates were adjusted more frequently and in larger amounts. With electronic trading and the advent of the retail arbitrage trader, the inconsistencies between spot exchange rates are more visible and, thus, the inconsistency is more quickly noticed, and the trade becomes too crowded to be significantly profitable.

However, the IFE, as well as additional methods of trade confirmation, can be incorrectly assessed. In this case, even though there may not be an empirical advantage to a trade, there may be a psychological one if the spot predictions have been incorrectly assessed and acted upon.

The Bottom Line

The Fisher Effect is a theory describing the relationship between both real and nominal interest rates, and inflation. The theory states that the nominal rate will adjust to reflect the changes in the inflation rate in order for products and lending avenues to remain competitive. It is a theory that is sometimes applied to currency pairs in order to profit from price discrepancies through a trading style called arbitrage.