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.
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.