The Fisher effect or hypothesis is an economic theory that investigates and describes the correlation between inflation and interest rates. Invented by economist Irving Fisher in the early 1930s, the equation proposes that the real interest rate equals the nominal interest rate minus the expected inflation rate.
The theory states that any expected disparity in the exchange rate of two currencies is equal to the nominal rate difference between the currencies in question. Therefore, in theory, you can predict how the rates at which currencies of two countries will trade by looking at their nominal rates.
However, for the theory to work in its simplest form, both countries in question must allow risk-free aspects of their capital to float freely from one country to the other.
The way this translates in real life is that real interest rates and inflation pull in opposite directions unless nominal interest rates mirror the behaviour and direction of inflation.
Background Information for the Fisher effect Theory
This theory uses a pure interest rate model rather than one based on inflation or a combination of the two. The decision is based on the economist’s assumption that the real interest rate is not affected by any changes in future inflation rates. He assumed because both rates are equalised over a period of time through market arbitrage.
All inflation is usually embedded in the nominal interest rates and provided for in the market projections for the changes in the price of the currency. Irving also theorised that spot currency prices would eventually achieve parity perfect ordering markets.
This phenomenon is called the Fisher Effect and is somewhat different from the International Fisher Effect. In essence, monetary policies set by the central bank have an impact on the effect as they determine a country’s nominal rate.
The Fisher Effect versus the IFE
According to Fisher, nominal rates reflect future inflation increases and real return rates. This means that real interest rates are equal to the nominal rate less the expected rate of inflation. So, take the real rate minus the expected inflation rate to get an accurate figure.
The IFE uses this theory to conclude that currency prices would go up or down in proportion to the rates of nominal interest between the countries. The rates would reflect inflation differences through purchasing power parity between two countries under review.
How Does the International Fisher Effect Explain the Economic Standing of a Country?
Given that the Fisher Effect is an economic theory that shows the expected disparity in the money market, policymakers can use it to predict changes in money supply based on the interest rate and inflation and not just the inflation variable like most theories.
It can be concluded that real interest rates are the best indicator of a country’s economic health. Economies with lower rates also have lower inflation levels. On the other hand, lower inflation levels keep the prices of goods and services low, thereby making them affordable to all.
On the other hand, higher interest rates lead to high levels of inflation and decreased value of the said currency. This, in turn, leads to an increase in the prices of commodities and services.
Quick Facts About The Fisher effect:
- Inflation affects products pricing
- Real rates are the best indicator of the economy’s health
- Currency prices affected by interest rates