Fisher's Effect

Discussion on Fisher's Theory and it's effect on money supply.
The Fisher effect is an economic theory 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.

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1. Fisher Effect

2. What is the Fisher Effect? The Fisher effect is an economic theory 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 Effect is an economic hypothesis stating that the real interest rate is equal to the nominal rate minus the expected rate of inflation.

3. BREAKING DOWN Fisher Effect 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.

4. Nominal Interest Rate and Real Interest Rate Nominal interest rates reflect the financial return an individual gets when he or she deposits money. For example, a nominal interest rate of 10% per year means that an individual will receive an additional 10% of his deposited money in the bank . Unlike nominal interest rate, 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 overtime 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 overtime.

5. Effect on Money Supply The Fisher effect is more than just an equation: It shows how the money supply affects nominal interest rate and inflation rate as a 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. It will, however, directly reflect changes in the nominal interest rate.

6. Why Does Fisher Theory Matters The Fisher effect is an important tool by which lenders can gauge whether or not they are making money on a granted loan. Unless the rate charged is above and beyond the economy’s inflation rate, a lender will not profit from the interest. Moreover , according to Fisher's theory, even if a loan is granted at no interest, a lending party would need to charge at least the inflation rate in order to retain purchasing power upon repayment.

7. Limitations of the Fisher Effect Elasticity of demand to interest rates. - In periods of confidence and rising asset prices, high real interest rates may be ineffective in reducing demand. Therefore, in some circumstances, Central Banks may need to increase the real interest rate to have an effect . Liquidity Trap - In a liquidity trap reducing nominal interest rates can have no effect on boosting spending. Lower interest rates don’t encourage investment because the economic climate discourages investment and spending . Breakdown between base rates and actual bank rates - In some circumstances, there is a breakdown between base rates set by Central Bank and the actual interest rate set by banks.