Fisher’s theory is also known as Fisher’s Hypothesis or sometimes as Fisher’s effect. This theory was put forward by a very famous economist named Fisher Irving. This theory is based on the relationship between inflation and interest rates (both real and nominal). The theory proposes that the real interest rate is the one that has been adjusted for inflation (Uribe, 2022). We can write this phenomenon in mathematical form as such.

Real interest rate = nominal interest rate – expected inflation

Hence, we observe that according to this theory the real interest rate tends to decrease as the inflation increases if the nominal interest rate is not increasing at the same rate as the inflation.

Fisher’s Theory of Interest Rates [Explained with examples]

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This theory of Fisher is now used in macroeconomics for determining the supply of money against the international trade of the currency. In microeconomics, this theory is used to determine if the investment is going to be profitable or not.

 

Main causes behind fluctuations in the Rate of Inflation

If we observe inflation from a wider lens and the perspective of an entire economy, then there can be many factors impacting the price rate of goods and services in the country. one of the most common and practical reasons for an increase in inflation is an increase in the price of raw materials and the production process. An increase in inflation has many setbacks for the overall economy but it also has some benefits (Conard, 2018).

The government has to analyze all the factors impacting the inflation rate and decide the best strategy and plan for the progress of the economy. For example, if China produces plastic toys and the price of gas increases, it will cost more for the manufacturing company to manufacture the same product. Hence, to maintain the profits of the company owner will have to increase the price of the product. Inflation is also sometimes the result of fiscal policy, and it is strategically rose by the government to balance other economic factors.

According to another very famous theory the quantity theory of money, the demand and supply of a certain currency decide the rate of inflation. This phenomenon can also be applied to determine the relationship between interest rates and the supply of money (Humphrey, 2018). If the interest rate in the economy increases, the supply of money decreases and as less money is in the hands of consumers, they tend to demand lesser goods and services. Hence, inflation decreases.

 

Relationship between Interest rate and Inflation

The relationship between interest rate and inflation is very important to understand, both factors are essential for keeping the overall economy stable. Both factors share an inverse relationship. If the inflation in a country is increasing, the interest rate will decrease and as a result, the investors will not save their money in banks and the money circulation will increase (Crowder & Hoffman, 2016). And similarly, if the inflation within a country is decreasing the interest rate will increase and people will find it more profitable to invest their money therefore the circulation of money in the economy will decrease.

 

Application in Microeconomics

Taking the example of a Bank, the nominal interest rate determines the return on the deposit made by the investor. If there is an 8% nominal interest rate applied on the deposit per year, then there will be an 8% return on the deposit the next year (we are assuming that the investor did not withdraw any money from the account in the following year). The real interest rate on the other hand focuses on purchasing power.

Taking the same case, the money in the account at the end of one year will increase by 8% and if the inflation remains the same, the investor will be able to purchase 8% more goods and services (Wilcox, 1990). If inflation increases by 6% at the end of one year, then the real interest rate will increase by 2% only. As a result, the investor will not be able to purchase 8% more goods with returns of 8%. The purchasing power determines the number of goods that a consumer can buy by spending a certain amount of money.

 

Application in Macroeconomics

The relationship between interest rate and inflation plays a very crucial role in macroeconomics. Whenever the inflation within an economy fluctuates due to the monetary policy put forward by the central bank, it also impacts the nominal interest rate of the country and to counter this change, the government decides the supply of money. For example, if a country is faced with inflation of 9% and the nominal interest rate increases by 7%. The real interest rate will be determined by adjusting the nominal interest rate according to the rate of inflation. In this case, the real interest rate will decrease because the nominal interest rate is not changing at the same rate as the increasing inflation rate.

Given the new conditions, the government will need to maintain the economy by adjusting the supply of money. If the nominal interest rate increases people find it more beneficial to save money in banks, and this causes a shortage of money rotating in the market. Hence, to maintain an equilibrium the government will increase the supply of money.

 

The International Fisher Effect

An International Fisher effect is an extended form of the general theory of fisher and this effect is used for analyzing forex trading. The difference between the international fisher effect and the standard theory of fisher is the fact the IFE focuses on the present and future risks of nominal interest rates interest of nominal interest rate and inflation. This effect is mostly used in determining the spot price of any specific currency in the stock exchange. The International fisher effect was more frequently used when the central banks used monetary policies and the nominal interest rate was adjusted more frequently and more dramatically.

 

Conclusion

Fisher’s theory of interest rates plays a very important role in economics. This theory is focused on very important economical factors. Inflation and both nominal and real interest rates are very important elements on which the stability of an economy depends. In modern times this theory has been extended and applied to various levels of the economy. In conclusion, Fisher’s theory of interest rates states that the real interest rate can be determined by subtracting the expected inflation from the nominal interest rate. Real interest rate gives a much clearer idea of the actual difference that an investor will face after the end of the agreed investment period.

 

References

Conard, J. W. (2018). Introduction to the Theory of Interest.

Crowder, W. J., & Hoffman, D. L. (1996). The Long-Run Relationship between Nominal Interest Rates and Inflation: The Fisher Equation Revisited. Journal of Money, Credit and Banking, 102-118.

Humphrey, T. M. (1983). The Early History of the Real/Nominal Interest Rate Relationship. FRB Richmond Economic Review.

Uribe, M. (2022). The Neo-Fisher Effect: Econometric Evidence from Empirical and Optimizing Models. AMERICAN ECONOMIC JOURNAL: MACROECONOMICS, 14(3). Retrieved from https://www.aeaweb.org/articles?id=10.1257/mac.20200060

Wilcox, J. A. (1990). Nominal Interest Rate Effects on Real Consumer Expenditure. Business Economics, 31-37.