A:

The Fisher effect is a theory first proposed by Irving Fisher. It states that real interest rates are independent of changes in the monetary base. Fisher basically argued that the real interest rate is equal to the nominal interest rate minus the inflation rate.

Most economists would agree that the inflation rate helps to explain some differences between real and nominal interest rates, though not to the extent that the Fisher effect suggests. Research by the National Bureau of Economic Research indicates that very little correlation exists between interest rates and inflation in the way Fisher described.

Nominal Vs. Real Interest Rates

On the surface, Fisher's contention is undeniable. After all, inflation is the difference between any nominal versus real prices. However, the Fisher effect actually claims that the real interest rate equals the nominal interest rate minus the expected inflation rate; it is forward-looking.

For any fixed interest-paying instrument, the quoted interest rate is the nominal rate. If a bank offers a two-year certificate of deposit (CD) at 5%, the nominal rate is 5%. However, if realized inflation during the lifetime of the two-year CD is 3%, then the real rate of return on the investment will only be 2%. This would be the real interest rate.

The Fisher effect argues that the real interest rate was 2% all along; the bank was only able to offer a 5% rate because of changes in the money supply equal to 3%. There are several underlying assumptions here.

First, the Fisher effect assumes that the quantity theory of money is real and predictable. It also assumes that monetary changes are neutral, especially in the long run – essentially that changes in the money stock (inflation and deflation) only have nominal economic effects, but leave real unemployment, gross domestic product (GDP) and consumption unaffected.

In practice, nominal interest rates are not correlated with inflation in the way that Fisher anticipated. There are three possible explanations for this: that actors do not take expected inflation into consideration, that expected inflation is incorrectly taken into consideration or that rapid monetary policy changes distort future planning.

Money Illusion

Fisher later held that the imperfect adjustment of interest rates to inflation was due to the money illusion. He wrote a book about the topic in 1928. Economists have debated the money illusion ever since. In essence, he was admitting that money was not neutral.

The money illusion actually traces back to classical economists such as David Ricardo, though it did not go by that name. It essentially states that an introduction of new money clouds the judgment of market participants, who falsely believe that times are more prosperous than they actually are. This illusion is only discovered as such once prices rise.

The Problem of Constant Inflation

In 1930, Fisher stated that "the money rate of interest (nominal rate) and still more the real rate are attacked more by the instability of money" than by demands for future income. In other words, the impact of protracted inflation affects the coordinating function of interest rates on economic decisions.

Even though Fisher came to this conclusion, the Fisher effect is still touted today, albeit as a backwards-looking explanation rather than a forwards-looking anticipation.

RELATED FAQS
  1. What is the Difference Between Real and Nominal Interest Rates?

    Learn about nominal interest rates and real interest rates and the difference between the two (hint: one of them takes into ... Read Answer >>
  2. How does inflation affect fixed-income investments?

    Learn about the ways inflation can harm fixed-income investments. Find out how to monitor the impact of inflation using common ... Read Answer >>
  3. Calculate the difference between nominal value and real value of stock shares

    Explore the impact of real value and nominal value on stock trading. Find out how these values are assigned and what causes ... Read Answer >>
  4. What is the relationship between inflation and interest rates?

    As interest rates are lowered, more people are able to borrow more money, causing the economy to grow and inflation to increase. ... Read Answer >>
Related Articles
  1. Trading

    An introduction to the international fisher effect

    The Fisher models have the ability to illustrate the expected relationship between interest rates, inflation and exchange rates.
  2. Investing

    Don't Let Fear Marketing Influence Your Investments

    If an annuity seems right for your retirement, don't let fear marketing scare you into selling it.
  3. Personal Finance

    How Interest Rates Can Go Negative

    Central banks from Europe to Japan have implemented a negative interest rate policy (NIRP) in order to stimulate economic growth.
  4. Investing

    Illumina Closes Slightly Up on Takeover Reports

    It seems that DNA sequencing company Illumina (NASDAQ: ILMN) might be in play. Citing an individual "claiming to have knowledge of the matter," Streetinsider.com reports that the company has ...
  5. Insights

    The Importance Of Inflation And GDP

    Learn the underlying theories behind these concepts and what they can mean for your portfolio.
  6. Investing

    Disney's Lucasfilm Strikes Back at Rumors

    Lucasfilm denied rumors that it would digitally re-create the late actress Carrie Fisher.
  7. Insights

    Inflation's Impact on Stock Returns

    Learn about the impact inflation can have on stock returns. Find information on what types of stocks perform during times of high inflation or low inflation.
  8. Insights

    How Interest Rates Affect The U.S. Markets

    Interest rates can have both positive and negative effects on U.S. stocks, bonds and inflation.
  9. Investing

    Top 5 Shareholders of HSBC

    Learn about the operations and investment strategies of the 5 largest HSBC institutional shareholders.
RELATED TERMS
  1. Fisher Effect

    An economic theory proposed by economist Irving Fisher that describes ...
  2. Nominal Rate Of Return

    The nominal rate of return is the amount of money generated by ...
  3. Nominal Value

    The stated value of an issued security. Nominal value in economics ...
  4. Philip Fisher

    Philip Fisher was an acclaimed investor known for writing the ...
  5. Nominal Gross Domestic Product

    Nominal gross domestic product measures the value of all finished ...
  6. Fisher College of Business

    The school of business at The Ohio State University. In 2009, ...
Hot Definitions
  1. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  2. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  3. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  4. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  5. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  6. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
Trading Center