Fisher Effect

The “Fisher effect” refers to the tendency for the nominal interest rate and the inflation rate to march in step with each other. The nominal interest rate is the quoted market rate and is not adjusted for inflation. The linkage between the nominal interest rate and the inflation rate is one-to-one. A 1-percent increase in the inflation rate causes a 1-percent increase in the nominal interest rate. The relationship gets its name from Irving Fisher, an influential U.S. economist of the early 20th century.

Fisher developed his hypothesis to solve what was called “Gibson’s paradox,” a positive correlation between interest rates and the price level that was highly evident during the period of the classical gold standard. John Maynard Keynes named this correlation “Gibson’s paradox” and called it one of the most completely established empirical facts in quantitative economics. It was considered a paradox because there was no reason for it to exist in theory. Irving Fisher pointed out that although there was no reason for a positive correlation between the nominal interest rate and the price level, there was strong reason for positive correlation between nominal interest rate and the rate of change in the price level, meaning the inflation rate.

Fisher also observed that a weighted moving average inflation, with recent inflation rates having larger weights, correlated highly with the price level. Fisher concluded that in Gibson’s paradox the price level in effect acted as a proxy for weighted moving average of the inflation rate. In summary, inflation raises nominal interest rates, but not immediately. Over time, however, a steady and fully anticipated inflation rate is eventually fully reflected in nominal interest rates.

Fisher developed an equation that became the basis of his theory: nominal interest rate = real interest rate + expected inflation

According to this equation, in a zeroinflationeconomy, thenominalinterest rate equals the real interest rate. The real interest rate is determined by the productivity of capital and the thriftiness of savers. The productivity of capital creates a demand for lendable funds, the thriftiness of savers creates a supply of lendable funds, and the real interest rate adjusts to keep the two in balance. Inflation enters the picture on both thedemandsideandthe supply side.Onthe demand side, inflation creates an incentive tobeatinflationbyborrowingfundsandbuying capital goods before prices rise. Borrowers are willing to pay a higher interest rate because borrowing funds allows them to buy before prices go up. On the supply side, inflation means that money used to repay a loan has less purchasingpowerthan the money that was loaned out. Therefore, lenders must demand a higher rate of interest to compensate for inflation. In an inflationary economy, lenders demand a higher interest rate, and borrowers have an incentivetopayahigherinterest. Tokeepthesupply and demand for lendable funds in balance the nominal interest rates has to change on a one-to-one basis with the expected inflation rate.

The Fisher effect is highly evident in short-term interest rates, such as those earned by three-month treasury bonds. For short-term interest rates, the actual inflation rate acts as a reasonable proxy for the expected rate of inflation. For longer-term interest rates, the Fisher effect becomes difficult to test because expected inflation is not subject to direct measurement.