International Fisher effect

In the Fisher effect, named after the economist Irving Fisher, is a relationship between inflation, nominal and real interest rate, which says that increases in inflation are reflected in proportional increases in the nominal interest rate.

In mathematical form, the Fisher effect can be expressed as follows:

With = change in the nominal interest rate and the inflation rate = change

Based on the Fisher effect is the following relationship:

I = nominal interest rate, inflation rate = r = real interest rate

If and r are sufficiently small, the well-known Fisher equation can be derived from

Significantly in Fishers theory is the strict separation of monetary and real sphere (classical dichotomy ). After that, the real interest rate is determined in the capital market as the interest rate that equalizes demand for capital goods and savings. Monetary factors play no role in the determination of the real interest rate. It therefore follows that changes in the inflation rate can not affect the real interest rate () and thus be reflected directly in the nominal interest rate.

The above formulation of the Fisher effect implies that the inflation rate is known. In reality, the actual inflation rate is known, however only with time delays. In this respect relates a more realistic formulation of the Fisher effect a change of the expected rate of inflation.

In this form, providing somewhat of changes in inflation expectations on the current nominal interest rate.

International Fisher Effect

The International Fisher Effect (also: Fisher - Open) transfers the statements of the Fisher effect to international connections. Basically, the following assumptions:

  • The real return rates of the countries (h: home; f: foreign) are identical ( no arbitrage ).
  • The Fisher relation holds in both countries.

With

  • : Real interest rate
  • : Nominal interest rate
  • : Inflation

This implies that the following relationship applies:

Therefore, the extended Fisher relation holds:

This equation also implies that currencies with higher (expected) inflation rates should have higher interest rates. Deviations may be due to:

  • Not fully integrated capital markets (real rates of return do not match ).
  • Political risks.
  • Currency risks.
  • Other reasons.

For validity of the (relative) purchasing power parity theory also follows with the exchange rate in direct quotation and the time index:

This equation is called the Fisher - Open or International Fisher effect. It implies that currencies with low nominal interest rates tend to be enhanced compared to those with high nominal interest rates. ( The high nominal interest rates are justified by high inflation rates. )

  • Monetary policy
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