###### Production Function Approach to Analyz ...

The production function (or Solow growth model) is used to determine the economy’s... **Read More**

The Fisher effect was developed by an economist named Irvin Fisher. This effect is directly connected to the neutrality of money. It states that the real interest rate is stable in an economy and that changes in nominal interest rates result from changes in expected inflation.

Therefore, the sum of the required real rate of interest and the anticipated inflation rate over a given period gives us the nominal interest rate in the same economy.

Furthermore, money neutrality demands that the money supplied to an economy, or the rate of money growth, should only affect the expected inflation or inflation but not the required real interest rate. Therefore,

$$\text{Nominal interest rate} = \text{Real interest rate} + \text{Expected inflation}$$

And symbolically put as:

$$R_{nominal}= R_{real} + \pi^e$$

Where

\(R_{nominal}\) refers to the nominal interest rate;

\(R_{real}\) refers to the real rate of interest; and

\(\pi^e\) refers to expected inflation.

The Fisher effect also shows that the expectation of future inflation exists fully in every nominal interest rate. Let us take an example of a 12–month Australian government bond offered a 4 percent yield. We assume again that the bond investors wished for a reward of 2 percent real interest rate and 2 percent expected inflation.

$$R_{nominal}= R_{real} + \pi^e = 2\% + 2\% = 4\%$$

A nominal interest rate of 4 percent would be enough to deliver the desired real reward of 2 percent as long as the expected inflation does not exceed 2 percent. In another case, let us assume that investors alter their view of anticipated inflation to 3 percent over the next 12 months. Due to higher expected inflation, the bond rate would increase to 5 percent to make up for the investors. Thus, the required real reward of 2 percent will be preserved.

$$R_{nominal}= R_{real} + \pi^e = 2\% + 3\% = 5\%$$

Notably, the above example has a setback. Investors can never be certain of future values of economic variables such as real growth and inflation. This is compensated by a risk premium. Therefore, the greater the uncertainty, the greater the needed risk premium. Also, the smaller the uncertainty, the smaller the required risk premium. All nominal interest rates are made up of three components: a required real return, a factor compensating investors for expected inflation, and a component to compensate investors for uncertainty.

QuestionGiven a yearly nominal interest rate of 5% and a yearly expected inflation of 2%, the real interest rate is

closest to:A. 3%

B. 8%

C. 2.5%

The correct answer is

A.

Solution

\(\text{Nominal interest rate} = \text{Real interest rate} + \text{Expected inflation}\)

\(5\% = \text{Real interest rate} + 2\%\)Rearranging the equation:

\(\text{Real interest rate} = 5\% – 2\% = 3\%\)