13.10 : The Fisher Effect

The Fisher Effect, named after economist Irving Fisher, is pivotal in financial theory. It illustrates how inflation impacts the economy's interest rates. The Fisher Effect states that the nominal interest rate is the sum of the real interest rate and expected inflation.

Understanding this concept is essential for various financial activities, from setting savings account yields to pricing loans and bonds. It helps investors assess the true value of their investments in terms of future buying power. For instance, if the real interest rate is fixed and inflation expectations increase, lenders will demand higher nominal rates to compensate for the anticipated erosion of purchasing power. Conversely, if inflation expectations fall, nominal rates would decrease, assuming the real rate remains constant.

Central banks also use the Fisher Effect when setting monetary policies. By manipulating real interest rates through changes in the nominal rate, they aim to influence economic activity, inflation, and employment levels. For policymakers, anticipating shifts in inflation and adjusting nominal rates can stabilize the economy and guide fiscal decisions.