Read the information provided below to learn more about this Economic concept.
The Fisher equation is an Economic concept that explains the relationship between real interest and nominal interest rates. This relation is calculated under the inflation effect. According to this equation, the nominal interest rate is equal to the total of the inflation and interest rate.
Inflation + Real interest rate = Nominal interest rate
The Fisher equation explains the situation, in which lenders or investors ask for an extra reward, in order to compensate for their purchasing power loss, due to inflation. When the rates of real interest decrease, inflation goes up. The only exception is when the rates of nominal interest go up at a rate which is similar to that of inflation.
This equation has been derived from the Fisher Effect, which is an Economic theory originated by Irving Fisher, an eminent Economist. In examining money supply and trading international currencies, the Fisher Effect is quite essential.
In Economics and Finance, the concept of the Fisher equation is used extensively to calculate the return on investments or predict both real and nominal interest rates’ behaviour.
The Fisher equation shares a significant relation with monetary policy. From the equation, we get to know that the monetary policy moves the nominal interest rate and inflation in the exact same direction. However, the real interest rate does not get affected by monetary policy.
The Fisher equation is mathematically expressed using the following formula:
(1+i) = (1+r)(1+π)
‘i’ represents the nominal interest rate,
‘r’ represents the real interest rate and,
‘π’ represents the rate of inflation.
There is also another version of this formula:
Let us assume that in an economy, the rate of nominal interest is 8% per year; however, the inflation rate is 3% per year. Thus, if one has $1 in the bank this year, he/she will receive $1.08 in the coming year. But, as goods become 3% more expensive, the individual’s $1.08 will not be sufficient to buy 8% extra goods in the coming year. The person can only buy 5% extra goods in the next year with his/her $1.08. This is the reason why 5% is the real interest rate.
This relationship can become fully clear if the rate of nominal interest is equal to the rate of inflation. If one earns 8% per year for a certain amount of money kept in the bank, but the prices of goods have increased by 8% in that year, one actually gets a zero return for that amount of money. You can understand the situation better with the help of the following equation:
Nominal interest rate – inflation rate = rate of real interest
8% – 3% = 5%
8% – 8% = 0%
Now you know the basics of the Fisher equation. The information provided above will help you get a good understanding of this important concept in Economics. You can also use the details provided here to write a quality academic assignment paper on the same topic. Also, if you are doing any research work on this Economic concept, this blog will work as a good reference.
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