Next video:
Loading the player...

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. 


Related Articles
  1. Insights

    Interest Rates: Nominal and Real

    An interest rate is the cost of borrowing money, expressed as a percentage of the loan amount. Interest rates are the primary yardstick for measuring how much return lenders will get. However, ...
  2. 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.
  3. Insights

    The Taylor Rule: An Economic Model for Monetary Policy

    Learn about the The Taylor Rule, an interest rate forecasting model that's helped central banks around the world adjust their rates to balance out inflation.
  4. Investing

    Maximize Your Real Rate of Return for Retirement

    Learn to understand how to plot your portfolio's real rate of return for retirement planning to safeguard your retirement funds against inflation.
  5. Insights

    How Inflation Affects Your Net Worth

    When calculating your net worth, don't forget to take inflation into account.
  6. Trading

    Coping With Inflation Risk

    Inflation is less dramatic than a crash, but it can be more devastating to your portfolio.
  7. Insights

    How Inflation Rates Impact Your Retirement Savings

    Understanding the risks and likely rate of inflation can help investors craft a strategically, well-diversified retirement portfolio.
  8. IPF - Banking

    How Inflation Affects Your Cash Savings

    Prices tend to rise over time and this inflation can cut into the value of your savings. Here are some ways you can manage the situation.
  9. Insights

    9 Common Effects of Inflation

    Is inflation ever good? If you like your job it is.
Trading Center