Fisher hypothesis

The Fisher hypothesis is the proposition by Irving Fisher that the real interest rate is independent of monetary measures, especially the nominal interest rate. The Fisher equation is

:$r\_r\; =\; r\_n\; -\; pi^e.$

This means, the real interest rate ($r\_r$) equals the nominal interest rate ($r\_n$) minus expected rate of inflation ($pi^e$). Here all the rates are continuously compounded. For simple rates, the Fisher equation takes form of

:$r\_r\; =\; (1+r\_n)/(1+pi^e)\; -\; 1.$

If $r\_r$ is assumed to be constant, $r\_n$ must rise when $pi^e$ rises. Fisher Effect: The one for one adjustment of the nominal interest rate to the expected inflation rate.

According to the principle of monetary neutrality, an increase in the rate of money growth raises the rate of inflation but does not affect any real variable. An important application of this principle concerns the effect of money on interest rates. Interest rates are important variables for macroeconomists to understand because they link the economy of the present and the economy of the future through their effects on saving and investment.

To understand the relationship between money, inflation and interest rates you need to understand nominal interest rate and real interest rate. The nominal interest rate is the interest rate you hear about at your bank. If you have a savings account, for instance, the nominal interest rate tells you how fast the number of dollars in your account will rise over time. The real interest rate corrects the nominal rate for the effect of inflation in order to tell you how fast the purchasing power of your savings account will rise over time. An easy estimation of the real interest rate is the nominal interest rate minus the expected inflation rate (Note that this estimate is unwise when looking at compounded savings.)

Real interest rate= Nominal Interest Rate - Expected Inflation Rate

Nominal Interest Rate= Real interest Rate + Expected Inflation Rate

If inflation permanently rises from a constant level, let's say 26%/yr., to a constant level, say 88%/yr., that currency's interest rate would eventually catch up with the higher inflation, rising by 4 points a year from their initial level. These changes leave the real return on that currency unchanged. The Fisher Effect is an evidence that in the long-run, purely monetary developments will have no effect on that country's relative prices.

ee also

The International Fisher Effect predicts an international exchange rate drift independent of inflation - that is, entirely based on the respective national nominal interest rates. [cite web | title = International Fisher Effect (IFE) | url = http://www.investopedia.com/terms/i/ife.asp | accessdate = 2007-11-03 ] (Though differential real rates will give the same exchange rate drift if inflation is internationally harmonized.)

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