Irving Fisher, a well-known economist created an economic theory which goes by the name ‘the Fisher effect’. The theory narrates the relationship between both real and nominal interest rates and inflation; the terms with which we are very familiar.
The real interest rate equals the nominal interest rate minus the expected inflation rate; as stated by the Fisher effect. As a result, inflation rises and real interest rates drop unless nominal rates increase at the same rate as inflation.
Nominal Interest Rates and Real Interest Rates
The financial return that an individual receives when he/she deposits money can be reflected as nominal interest rates. For instance, an individual receives an added 20% of his deposited money in the bank on his nominal interest rate of 20% per year.
Different from the nominal interest rate, the real interest rate takes into account the purchasing power in the calculation.
The nominal interest rate is the provided real interest rate that showcases the economic growth embellished over the period to a certain amount of currency or money billed or due to a financial creditor. The actual interest rate is the money that reflects the purchasing power of the lent money as it blooms over the period.
The International Fisher Effect
The international Fisher effect which can also be referred to as ‘IFE’ is also an economic theory stating that the expected difference between the exchange rate of two currencies is roughly equal to the disparity between their nations’ nominal interest rates.
The international Fisher effect is based on the examination of interest rates allied with future and present non-hazardous investments, for instance, Treasuries, and is used to help foresee the currency movements. The other methods only use inflation rates in the prediction of shifts of the exchange rate, rather than working as a collective view relating inflation and currency’s appreciation or depreciation’s interest rates. These types of methods are great in contrast with the IFE.
The theory develops from the notion that real interest rates are self-regulating and independent of other financial variables, such as providing a well signal of the health of a particular currency within an international market, and variations in a country’s monetary policy. The countries with lesser interest rates will probably also experience lower levels of inflation which can equal to rise in the real value of the associated currency, comparatively to other countries.
By difference, countries with developed or higher interest rates will go through depreciation in the values of their currency.
Calculating the International Fisher effect
The IFE can be calculated by the formulae stated below:
E ≈ i1 – i2
E= the percent change in the exchange rate
i1= country A’s interest rate
i2= country B’s interest rate
The Fisher Effect and the International Fisher effect
The Fisher effect and the international fisher effect are correlated models but are not substitutable or interchangeable. The Fisher effect states that the amalgamation of the estimated rate of inflation and the real rate of return is denoted in the nominal interest rates.
Whereas, the IFE enlarges on this effect, signifying that because estimated inflation rates are reflected by nominal interest rates and inflation rates which drive the currency exchange rate changes, then currency changes are equivalent to the disparity between the countries’ nominal interest rates.
The Fisher equation
A notion that defines the relationship between real interest rates and nominal interest rates under the influence of inflation is known as the Fisher equation. The nominal interest rate is equal to the sum of the real interest rate plus inflation; as the equation conditions.
The Fisher equation ever so often is used in circumstances where creditors or investors ask for an added reward to reimburse for losses in purchasing power (PP) due to the high inflation.
This notion is broadly or commonly used in the fields of economics and finance. Generally used for calculating the returns on investments or in foreseeing the behavior of nominal and real interest rates. For instance, when a depositor/stockholder/investor wants to determine the real interest rate he has earned on an investment after accounting for the inflation’s effect.
One certain importance of the Fisher equation is interrelated with monetary policy. The equation tells that the monetary policy of the nation moves both the price rise or inflation and the nominal interest rate together in the same direction. Alternatively, the monetary policy usually does not affect the real interest rate.
The Fisher equation formula
Fisher equation formulae can be seen stated as below:
(1+i) = (1+r) (1+π)
i= the nominal interest rate
r= the real interest rate
π= the inflation rate
Nevertheless, you can also use the estimated and simplified version of the preceding formulae, which is stated below:
i ≈ r + π
That was all about the Fisher effect and its calculation. Hope this article helped in you any way possible! Get updated with the latest finance news by Financeshed.