Limited Time Offer: Save 10% on all 2021 and 2022 Premium Study Packages with promo code: BLOG10    Select your Premium Package »

The Fisher Effect

The Fisher Effect

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.

Example of the Fisher Effect

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.

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

The Risk Premium

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. 

Question

Given 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:

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

Featured Study with Us
CFA® Exam and FRM® Exam Prep Platform offered by AnalystPrep

Study Platform

Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Online Tutoring
    Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

    Video Lessons



    Sergio Torrico
    Sergio Torrico
    2021-07-23
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    diana
    diana
    2021-07-17
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    2021-07-16
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    2021-06-28
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Marwan
    Marwan
    2021-06-22
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    2021-05-10
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.