Explain the Fisher effect and analyse its role in linking the nominal and

real rate of interest. Can interest rates be negative? Critically discuss in

the context of the Japanese experience of deflation since the early 1990s

- EC 247 Term Paper -

Michael Horn

Department of Economics

University of Essex

January 2008

Abstract

This term paper theoretically analyses the Fisher equation, the Fisher effect and the
possibility of negative interest rates. The results of this analysis will then, after a
brief discussion of the deflation in the Japanese economy since the early 1990s, be
applied to this situation.
EC247 Term Paper - Michael Horn 2

1 Introduction
The Fisher effect is an important theoretical concept in macroeconomics and financial
economics. To explain it to a broader extend and subsequently apply it to the situation of
the Japanese economy since the 1990s, the term paper is divided into three main sections:

Section 2 will cover the Fisher equation and the Fisher effect. It will provide the rel-
evant definitions, economic intuition and implications, as well as the mathematical
derivation.

Section 3 will answer the question whether interest rates can be negative.

Section 4 will give a brief overview of the deflation in Japan since the early 1990s and
apply the theory and conclusions of sections 2 and 3 to this situation.

2 The Fisher effect

The Fisher effect1 , also called Fisher Hypothesis is defined as “the one-for-one relation
between the (expected) inflation rate and the nominal interest rate” ([2] p. 92). Mathe-
matically: ∆i = ∆π e . This will be explained in greater detail in section 2.2. Before that,
we have to take a look at the base of the Fisher effect: The so-called Fisher equation.

2.1 The Fisher equation

The Fisher equation is an identity that links the nominal interest rate, i, the real interest
rate, r and the (expected) inflation rate, π e and π, respectively. It can be used in ex ante
and ex post analysis. Thus there are two slightly different versions, depending on the
available information about the inflation rate:

• The ex ante Fisher equation adjusts the costs of borrowing (= the nominal
interest rate, see definition in section 2.1.1) for the effects of expected inflation: the
expected inflation rate, π e .

• The ex post Fisher equation decomposes the nominal interest rate into the real
interest rate and the actual (= realised ) inflation rate, π.
1
named after the economist Irving Fisher (*1867, †1947) of Yale University
EC247 Term Paper - Michael Horn 3

The commonly used approximation of the Fisher equation is:

i ≈ ra + π e ⇐⇒ ra ≈ i − π e (ex ante) (1)

and
i ≈ r + π ⇐⇒ r ≈ i − π (ex post) (2)

respectively.
The distinction between ex ante and ex post Fisher equation is necessary and becomes
clear when using time indices. Equations (1) and (2) then become:

a e
t it+1 ≈ t rt+1 + t πt+1 (ex ante) (3)

and
t it+1 ≈ t rt+1 + πt+1 (ex post) (4)

Equations (3) and (4) show the cost of borrowing money from period t to t + 1 (or,
equivalently, the yield of lending money from t to t + 1), t it+1 which is known ex post and
ex ante.
The major difference is that in equation (3) we only have the knowledge of period t whereas
in equation (4) we have the knowledge of period t + 1. Thus,

in equation (3), we don’t know the inflation rate in t + 1, πt+1 , and therefore have to
e
make expectations about it now (i.e. in t), t πt+1 . As a result we also don’t know the
actual real interest rate t rt+1 . In an ex ante analysis we get the ex ante real price
a
for borrowing money from t to t + 1, t rt+1 by using the ex ante Fisher equation.

In equation (4), we know the actual value of π in t + 1 and can thus compute the actual
real interest rate t rt+1 .

2.1.1 Components of the Fisher equation

Before moving on to the Fisher effect it is necessary to become acquainted with the com-
ponents of equations (1) and (2):

• The nominal interest rate, i, is the interest rate one typically hears about. It is
defined as

(i) the nominal cost of borrowing money ([1] p. 4). It is the rate of interest that
a borrower has to pay for borrowing money. Hence, for lending the amount X
EC247 Term Paper - Michael Horn 4

the lender will charge the price i × X, the borrower therefore has has to repay
the amount X + i × X = (1 + i) × X.
(ii) The nominal interest rate can also be interpreted as “the cost of holding money”
([2] p. 95). Equation (2) can be rewritten as: i = r − (−π) where (−π) is the
real return of holding money because the real value of money declines at the
rate π. r is the opportunity cost of holding money, i.e. the foregone revenue of
not investing in other assets such as bonds. The cost of holding money therefore
is its opportunity cost minus its revenue.

As there many interest rates, it makes sense to focus on one. Without loss of
generality it is possible to use the annualised yield of money market securities as
nominal interest rate2 . In the following sections I will therefore focus on short term
interest rates as defined by the OECD3 .

• The real interest rate, r, measures the cost of borrowing (yield of lending) money
as loss (gain) in purchasing power. This is the interest rate that matters when
thinking about making an investment. It tells you how better off you really (i.e. in
real terms) are.

• The ex ante real interest rate, ra , measures the real cost of borrowing given
the inflation expectations. Ex ante, market participants only know i, but not π.
Therefore they also don’t know r. At this point in time the ex ante real interest rate
ra is the market expectation of the gain in purchasing power from lending money
from t to t + 1.

• The (actual) inflation rate, π, is the rate of change of the price level between two
Pt+1 −Pt
periods. Mathematically: πt+1 = Pt
, where Pt is the aggregate price level of the
current period, t and Pt+1 is the aggregate price level of the next period, t + 1. The
most common methods of determining the price level P in an economy are the CPI
(Consumer Price Index) and the GDP Deflator.
2
This has several advantages. In brief: money markets are short-term markets, mostly highly liquid
and have almost no risk premium. Central Banks usually adjust interest rates primarily through open
market operations which take place in the money market. Finally through arbitrage effects the interest
rates on other assets are linked to those determined in the money market and usually move in the same
direction.
3
“Short term rates are usually either the three month interbank offer rate attaching to loans given and
taken amongst banks for any excess or shortage of liquidity over several months or the rate associated
with Treasury bills, Certificates of Deposit or comparable instruments, each of three month maturity.”
[15]
EC247 Term Paper - Michael Horn 5

• The expected inflation rate, π e , is the expected rate of change of the price level
e −P
Pt+1
e t e
between two periods. Mathematically: πt+1 = Pt
, where Pt+1 is the expected
aggregate price level in the next period. Note: This expectation is made in pe-
riod t! The individuals need to have an opinion about Pt+1 in order to determine
their expected real interest rate ra which is necessary for them to evaluate whether
e
they want to invest/borrow or not. Hence, Pt+1 is the aggregate expectation of all
individuals about the price level in t + 1.

2.1.2 Implications of the Fisher equation

The Fisher equation has some interesting implications:

1. If π = 0, then i = r. In this case money is not loosing or gaining any value. Thus,
the cost of holding money is equal to its opportunity cost, the real return on assets.
Under this condition r cannot be negative, as i ≥ 0 (see section 3.1).

2. If π > 0, then i > r. For a positive inflation rate, nominal interest rates will always
exceed real interest rates.

3. If π < 0, then i < r. For a negative inflation rate (= an expected deflation), real
interest rates will always exceed nominal interest rates.
∂r
4. For a given i, the higher π, the lower r: ∂π
= −1
This case is particularly relevant if an economy is in a liquidity trap where i cannot
be influenced by the central bank anymore (as argued for Japan in section 4.2).

These implications refer to the ex post version of the Fisher equation. For the ex ante
version replace π with π e and r with ra .

2.1.3 Mathematical derivation of the Fisher equation

We start from the intuitive notion, that if an individual invests (=lends) an amount, X,
she will receive the amount X × (1 + i) after one period (see first definition of nominal
interest rates in section 2.1.1).
As explained in section 2.1, the amount at the end of the period will contain gains caused
by inflation and the “true”4 (i.e. real) revenue from investing money.
4
The “true” revenue is actually only equal to the real revenue when there are no distorting taxes
affecting the individual’s behaviour. Those are not part of our basic Fisher equations (1) and (2). In
order to get the true cost of borrowing one has to adjust for inflation and for these taxes. A simple
example is the ’real rate of return’ on p. 55 in [1].
EC247 Term Paper - Michael Horn 6

Mathematically the intuitive notion above can be stated as follows5 :

(1 + i) × X = (1 + r) × (1 + π) × X

Cancelling X gives:
(1 + i) = (1 + r) × (1 + π)

Expanding the brackets on the right side of the equation:

1 + i = 1 + r + π + (rπ)

=⇒ Actual Fisher equation: i = r + π + (rπ)

The term (rπ) is usually very small and can therefore be neglected in most cases6 .

=⇒ Approximation of the Fisher Equation: i ≈ r + π ⇐⇒ r ≈ i − π

which is equation (2).

2.2 Intuition of the Fisher Effect

Now, after understanding Fisher equation, we finally get to the Fisher effect: ∆i = ∆π e
and ∆i = ∆π, respectively.
It proposes a 1 : 1 relationship between i and π e (π in the ex post version). That is, an
increase in (expected) inflation leads to a proportional increase in the nominal interest
rate.
Analytically, the Fisher effect can be stated as follows7 :

∂i ∂i(ra , π e ) ∂ a
e
= e
= (r + π e ) = 1 f or ra constant (c.p.) (5)
∂π ∂π ∂π e

Hence, i changes, ceteris paribus, directly proportional to a change in π e .

The Fisher effect in the market for securities:

We will now analyse the effects of an increase in π e on i and on the price of a one-period
5
This is the derivation of equation (2). For equation (1) just substitute π e for π
6
This, of course, is not true in unusual economic situations with high inflation rates and/or high interest
rates. In these cases (rπ) won’t be insignificantly small anymore.
7
For ex post analysis substitute π e with π and ra with r. This also applies to the following part of
this section.
EC247 Term Paper - Michael Horn 7

discount bond8 , P which is depicted in figure 1, using the supply and demand model for
bonds outlined in [1] ch. 2:

- An increase in the expected inflation rate decreases the profitability of the bond
relative to other assets (↑ π e leads to ↑ i. The cost of borrowing, i, increases while
the profitability of other assets, r, remains constant).
=⇒ The demand for the bond B d decreases (from B1d to B2d ).

- As the expected real cost of borrowing money, (−π e ), has declined, it is more at-
tractive to borrow money.
=⇒ The bond supply B s increases (from B1s to B2s ).

Figure 1: Effect of an increase in the expected inflation rate, π e , on the nominal interest rate, i,
and the bond price, P (Source: [1] p.88)

The resulting effects are:

• ↑ π e ⇒↑ i: i increases directly proportional with π e (from i1 to i2 ). (See equation

(5))
F −P
• ↑ π e ⇒↓ P : We know the return on a discount bond9 : i = Re = P
.
We also know that i = ra + π e = i(r, π e ). That is: i is a function of r and π e .
a

Hence:
F −P F
i(ra , π e ) = ⇐⇒ P =
P i(ra , π e ) + 1
8
This is reasonable as most money market instruments are sold on a discount basis and their maturity
is < 1 year.
9
i = yield to maturity, Re = expected return, F = face value and P = purchase price of the bond (see
[1] p. 76).
EC247 Term Paper - Michael Horn 8

It follows that:
a e
∂P F × ∂i(r∂π,π
e
)
F
e
=− a e 2
=− <0 (6)
∂π [i(r , π ) + 1] [i(r , π e ) + 1]2
a

That is, an increase in the expected inflation rate, decreases the bond price (from
P1 to P2 ).

Finally, we have to distinguish between the long run and short run Fisher effect:

Long run: The Fisher equation exhibits the key assumption of the classical dichotomy.
The classical dichotomy is a macroeconomic hypothesis used in the analysis of the
economy in the long run. It is based on the idea of monetary neutrality. That is,
changes in money supply only affect nominal variables but not real variables. Hence,
the Fisher effect in the long run follows from the assumption of monetary neutrality.
Changes in money supply only affect the inflation rate and not the real interest
rate. A change in π can therefore only lead to a change in i, which is the proposed
1:1 relationship. Note: In this case the ex post and ex ante Fisher equation are
equivalent, as in the long run it is assumed that expectations are correct: π e = π
(⇒ ra = r).

Short run: The Fisher effect, as originally stated by Irving Fisher in [4] is a long run
concept. However, it is possible to see it in the short run, too. “When prices are
rising, the interest rate tends to be high but not so high as it should be to compensate
for the rise; and when prices are falling, the rate of interest tends to be low, but not
so low as it should be to compensate for the fall” ([4] p. 43). That is, in the short
run changes in the (expected) inflation rate do not only have monetary effects but
also affect real variables (here: r). Thus, π e and i are positively correlated but there
is not a 1:1-relationship in the short run.

3 Can interest rates be negative?10

The short answer to this question is: Nominal interest rates cannot be negative whereas
real interest rates can. The more detailed answer follows in the next two subsections.
10
The analysis in this section applies to the ex ante and ex post version of the Fisher equation. For
simplicity I will use the ex post version.
EC247 Term Paper - Michael Horn 9

3.1 Nominal Interest Rate

The nominal interest rate, i, is usually proposed to be non-negative. To understand the
reasoning behind this proposition we will use the second definition of i in section 2.1.1.
If i was negative, holding money would be profitable. It would be profitable to borrow
infinite amounts of money and simply keep the money until it has to be repaid. No rational
acting financial institution would lend money under these conditions.
Based on the definition of the cost of holding money: i = r − (−π), we can also conclude
that holding money would be more attractive than investing in assets other than money:
If i was negative we would either have

• a negative real return on assets other than money: r < 0, or

• a positive real return of holding money (that is a deflation): (−π) > 0), or

• both

In all cases the real return of holding money, (−π), is greater than the opportunity cost
of not investing in other assets, r: (−π) > r ∀ i < 0

However, there exists an explanation for negative nominal interest rates:

In [7], Daniel Thornton argues that the assumption of non-negative interest rates “assumes
that holding currency is costless” [7]. As holding money indeed bears risks (the money can
be stolen, lost or destroyed), individuals are willing to pay a price for the storage of their
money. In this case a negative i would be the “fee that individuals pay to hold deposits
or Treasury Bills” instead of holding cash.11
All in all, this idea doesn’t affect the logic of our previous analysis. The reasoning behind
the proposition of non-negative interest rates is still valid as there still exists a floor. The
suggestion of the article only implies that instead of having the floor at 0%, the nominal
interest rate has its floor at the maximum “willingness of individuals to pay for the risks
and costs accociated with holding cash” [7]. Thus, without loss of generality, I will stick
to the common proposition for the rest of the term paper.
11
A similar reason explains the occurrence of negative T-Bill rates in Japan in November 1998 (see [1]
p. 52) where banks yielded an interest rate of -0.004% on their T-Bills because holding T-Bills was more
convenient for them than holding cash. There was another occurrence of negative nominal interest rates
in Japan. On January 24th overnight call rates turned negative (to -0.01%). This, however was mainly
due to internal regulations of the banks [12].
EC247 Term Paper - Michael Horn 10

3.2 Real Interest Rate

In contrast to the nominal interest rate, the real interest rate r can head in both directions.
From the previous subsection we know that i ≥ 0. It follows that (−π) < r.
Hence, even if r < 0, it is always more attractive to invest in other assets (that is earn
the negative real return r) than to hold money. If i ≥ 0, the real return of holding money
(−π) is less than the return from investing in other assets r. That is, if r is negative, (−π)
will be even more negative.

4 Negative interest rates in the context of the Japanese

experience of deflation12
4.1 The Japanese experience of deflation since the early 1990s
The 1990s are often referred to as the “lost decade” because the remarkable expansion of
the economy after the second World War abruptly halted during this decade (see figure
2) and has been considerably lower by international standards since then (see figure 3).

Figure 2: Real GDP growth rates in Japan (Source: [14]). [2007 and 2008 growth rates are
estimates]
12
All figures in this section were created by the author using Microsoft Excel 2003 and data from the
mentioned source.
EC247 Term Paper - Michael Horn 11

Figure 3: Japan’s real GDP growth rates compared to the OECD, US and the EU (Source:
[15], own calculations13 )

The course of the (expected) inflation rate since the early 1990s, depicted in fig-
ure 4, can be explained by a dramatic decline in aggregate demand. The main contributors
to this development were:

• The burst of the “bubbles” in the stock and housing market at the beginning of the
1990s which had emerged during the 1980s due to loose monetary policy. This not
only lead to a sharp decrease in asset prices but also depressed investment spending
and consumer confidence ([3] p. 657f).

• Slow economic growth (see figure 2 and figure 3) which was triggered by the burst
of the “bubbles” and remained since then.

• Very high unemployment rates for Japanese standards which started increasing in
1991 at 2.10% and peaked at 5.40% in 2002, the highest recorded level since the
Japanese government started reporting this statistic in 1953 ([2] p. 324).

All these and other reasons (for a more detailed description see [8] and [3] pp. 655-664)
led to the deflation which endured from 1999 to 2005.

13
Each bar represents the difference between the real GDP growth rate of Japan in a specific
JP OECD
year and the real GDP growth rate of the EU, USA or OECD. Example: y1999 − y1999 (where
realGDPt −realGDPt−1
yt = realGDPt−1 is the growth rate of real GDP in period t)
EC247 Term Paper - Michael Horn 12

Figure 4: Actual (measured by the CPI) and expected inflation rates (forecasts by the OECD)
in Japan (Source: [15])

4.2 Negative interest rates in the Japanese economy since the

1990s
After bursting the “bubbles” through a tightening of monetary policy (The BOJ increased
interest rates from 1988 to 1990 to make assets other than stocks and real estate more
attractive and thereby direct money out of these two overheated markets), GDP growth
plummeted.

To stop the inflation rate from decreasing further and to boost GDP growth, the Bank
of Japan (BOJ) successively lowered the nominal interest rate again after the economic
downturn in the early 1990s and, from 1999 until 2006 effectively pursued a zero-interest-
rate policy (see blue line in figure 5). The Japanese nominal interest rate (as defined in
footnote 4), decreased from 7.72% in 1990 to 1.23% in 1995 and has remained below 1%
since then.

This led to a macroeconomic situation called, “Liquidity Trap”, as outlined by Paul Krug-
man in [9], [10] and [11]. In this is economic situation, nominal interest rates are very low
(almost 0%) which makes monetary policy, as a means of boosting GDP growth, ineffec-
tive. It is not possible for the central bank to lower the nominal interest rate through an
increase in money supply (because i ≥ 0, see section 3.1).
For this reason we can regard i as being fixed during the liquidity trap period.
EC247 Term Paper - Michael Horn 13

Figure 5: Components of the Fisher equation in the Japanese economy (Data for nominal interest
rate and expected inflation rate are from [15]; Real interest rate was computed by the author)

Figure 4 shows that the expected inflation rate has been almost equal to the actual
inflation rate throughout the whole period: π e ≈ π. Recognising that, we see that changes
in r cannot be explained by errors in expectations about the inflation rate (i.e. r ≈ ra ).

The data for nominal interest rates and (expected) inflation since the 1990s exhibit impli-
cations 1-3 from section 2.1.2.

1. There are cases where i ≈ r due to an (expected) inflation rate of almost 0% in 1996
and 2004, but also in 1986 and 1987.

2. Between 1980 and 1998 and in 2006 there was the most common case of a positive
expected inflation rate, π e > 0. This implies that i > r for this period which can be
seen in figure 5.

3. The Japanese deflation period (π e < 0) started in 1999 and remained until 2005.
During this period we can observe the third implication, that r > i.

The fourth implication of the Fisher equation in section 2.1.2. cannot be found in
figure 5. In the Japanese economy since approximately 1996, when Japan found itself in
the liquidity trap, the chart would probably look different if the Bank of Japan would have
implemented the suggestions of Paul Krugman (in [9], [10] and [11]). As monetary policy
is ineffective in such a situation, he suggested that the central bank should try to increase
EC247 Term Paper - Michael Horn 14

inflation expectations by credibly stating that it would increase inflation (e.g. by set-
ting an inflation target). By that (assuming that it would have worked) the increase in π e
would have decreased ra and in the long run r, as i would have remained constant14 . A low
(or even negative) real interest rate usually boosts investments and thereby increases GDP.

Although the Fisher Effect is a long-term concept, we can see this relationship (probably
not 1:1, see section 2.2) in most of our short-term data in figure 5. Whenever the inflation
rate increased (decreased), we observe an increase (decrease) in the nominal interest rate.

5 Conclusion
To sum up, the Fisher equation enables us to analyse real and monetary effects of the
nominal interest rate separately. The Fisher effect builds up on that and proposes a 1:1
relationship between the inflation rate and the nominal interest rate in the long run.
For Japan we can conclude that except for very few occurrences, among those the ones
mentioned in footnote 11, nominal interest rates were historically very low but not neg-
ative. There were only negative real interest rates in 1997 which could be interpreted as
an outlier due the the Asian financial crisis at that time.
Since 2003 economic expansion has been picking up again and Japan is showing signs of a
sustainable recovery from the slump. Japan might finally have escaped the liquidity trap.

14
This implication is very interesting: Although a central bank is unable to control the nominal interest
rate in a liquidity trap, it can affect the real interest rate by influencing inflation expectations.
EC247 Term Paper - Michael Horn 15

References
[1] Mishkin, F., Eakins, S. (2006) Financial Markets and Institutions 5th edition, Boston,
London: Pearson Addison-Wesley

[2] Mankiw, G. (2006) Macroeconomics 6th edition, New York: Worth Publishers

[3] Blanchard, O., Illing, G. (2005) Makroökonomie 3rd revised edition, Munich: Pearson

[4] Fisher, I., (1930) The Theory of Interest, New York: Macmillan

[5] Lee, J., Clark, C., Ahn, S. (1998) Long- and short-run Fisher effects: new tests and new
results, Applied Economics, 1998, 30, 113-124

[6] Ang, A., Bekaert, G., Wei, M. (2006) The Term Structure of Real Rates and Expected
Inflation, NBER Working Papers 12930, National Bureau of Economic Research, Inc.

[7] Thornton, D. (1999) Monetary Trends: Nominal Interest Rates: Less Than Zero?, The
Federal Reserve Banks of St. Louis

[8] Weinert, G. (2001) What Went Wrong in Japan: A Decade-Long Slump, Vierteljahrshefte
zur Wirtschaftsforschung, 70. Jahrgang, Heft 4/2001, S. 460474, HWWA-Hamburg Insti-
tute of International Economics

[9] Krugman, P. (1998) Japan’s trap, URL <http://web.mit.edu/krugman/www/japtrap.html>

[10] Krugman, P. (1998) Japan: Still trapped, URL

<http://web.mit.edu/krugman/www/japtrap2.html>

[11] Krugman, P. (1998) Its Baaack! Japan’s Slump and the Return of the Liquidity Trap,
Brookings Papers on Economic Activity 2, pp. 137-205

[12] The Economist (2003) “Japanese Banking Giveaway: Foreign banks are paying each other
to borrow yen”, February 8th 2003, p. 84

[13] The Economist (2007) “Going hybrid: A special report on business in Japan”, December
1st 2007

[14] World Economic Outlook Database for October 2007, URL

<http://www.imf.org/external/pubs/ft/weo/2007/02/weodata/WEOOct2007all.xls>

[15] OECD Factbook 2007: Real GDP Growth Rates, URL

<http://caliban.sourceoecd.org/vl=370370/cl=12/nw=1/rpsv/factbook/data/02-02-
01-T01.xls>