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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.

Real Interest Rate = Nominal Rate – Inflation Rate

It’s important that the real interest rate be positive so that a lender or investor knows he’s beating inflation.  If the real interest rate is less than zero, then the rate being charged on a loan or paid on a savings account is not beating inflation.  The lender or saver would be losing money from a purchasing power perspective. 

For instance, Fred has $1,000 and wants to buy a refrigerator that costs that exact amount, but he doesn’t need the refrigerator until next year.  So Fred places the $1,000 with his bank in a one-year certificate of deposit paying 5% interest.  This 5% is the nominal rate.  If inflation is 6% then, using Fisher’s formula, the real rate of interest on the CD is negative 1%. 

At the end of the CD’s term, Fred receives $1,000 plus $50 interest.  But because of the 6% inflation the price of the refrigerator is now $1,060.  Fred’s $1,050 is now not enough to buy the refrigerator.  From a purchasing power perspective, Fred actually lost money over the one-year term. 

 

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