The Fisher Effect

Irving Fisher, an American Economist who was born in 1867 and died in 1947, is considered to be one of the earliest American neoclassical economists (a neoclassical economist uses supply and demand to determine prices, output levels, and income distributions). In addition to the Fisher Effect, Irving Fisher is also famous for his theories on money and price levels, interest and capital, and debt deflation. He is recognized as being the first economist to distinguish between real and nominal interest rates.

The Fisher Effect states that the real interest rate is constant, and that the nominal interest rate and the expected inflation move together at a one to one rate. For clarity, the nominal interest rate is the interest rate that you receive before adjusting for inflation, while the real interest rate can be calculated by subtracting the inflation rate from the nominal rate. The real interest rate represents how fast your purchasing power changes over time. The relationships between these three rates are represented by the equation Real interest rate = Nominal Interest Rate - Expected Inflation Rate.

The Fisher Effect, also know as the Fisher Hypothesis or Fisher Parity, propositions that the real interest rate is independent of monetary measures. It states that real returns are equalized across countries through arbitrage. If expected real returns are higher in one country than another, then capital will flow to the country with the higher rate and equilibrium will be reestablished.

For continuously compounding rates, the Fisher Effect is represented by r_r = r_n ? ?^e, where r_r is the real interest rate, r_n is the nominal interest rate, and ?^e is the expected rate of inflation. For simple rates, the Fisher Effect equation is r_r = (1 + r_n) / (1 + ?^e) ? 1, where r_r is constant and r_n rises when ?^e rises.