FISHERS EFFECT

Definition of 'Fisher Effect' An economic theory proposed by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.

Fisher Effect
What It Is: The Fisher Effect is an economic hypothesis stating that the real interest rate is equal to the nominal rate minus the expected rate of inflation.

How It Works
In the late 1930s, U.S. economist Irving Fisher wrote a paper which posited that a country's interest rate level rises and falls in direct relation to its inflation rates. Fisher mathematically expressed this theory in the following way: R Nominal = R Real + R Inflation

Fisher Effect
Inflation Rate
.

Nominal Interest Rate

Example: If the real interest rate is held at a constant 5.5% and inflation increased from 2% to 3%, the Fisher Effect indicates that the nominal interest rate would have to increase from 7.5% (5.5% real rate + 2% inflation rate) to 8.5% (5.5% real rate + 3% inflation rate).

Behavior Pattern
Three behavior pattern of Fisher Effect: Complete Illusion, Adaptive Lag, And Rational Expectations