THE FISHER EFFECT

An increase (decrease) in the expected rate

of inflation will cause a proportionate
increase (decrease) in the interest rate in
the country.
 THE FISHER EFFECT

THE DIRECT PROPORTIONALITY

INFLATION RATES OF INTEREST

 THE FISHER EFFECT

THE DIRECT PROPORTIONALITY

INFLATION RATES OF INTEREST

 THE FISHER EFFECT

THE DIRECT PROPORTIONALITY

INFLATION RATES OF INTEREST

SIMPLE EXAMPLE!! VERY SIMPLE!!

 BUYER WANTS TO BUY AN ITEM OF WORTH

$110
SIMPLE EXAMPLE!! VERY SIMPLE!!

 BUYER WANTS TO BUY AN ITEM OF WORTH

$110
 NOT TODAY… RATHER ONE YEAR FROM
NOW
SIMPLE EXAMPLE!! VERY SIMPLE!!

 BUYER WANTS TO BUY AN ITEM OF WORTH

$110
 NOT TODAY… RATHER ONE YEAR FROM
NOW
 REASONS:
1. NOT TO BE USED UNTIL THAT TIME
2. STORAGE COST
EXAMPLE cont..

 FOR THE ITEM OF WORTH $110

EXAMPLE cont..

 FOR THE ITEM OF WORTH $110

EXAMPLE cont..

 FOR THE ITEM OF WORTH $110

RATE OF 10%
RETURN
EXAMPLE cont..

 FOR THE ITEM OF WORTH $110

RATE OF 10%
RETURN

SO, AFTER 1 YEAR, THE

TOTAL WILL BE
$110
EXAMPLE cont..

INFLATION 5%
EXAMPLE cont..

INFLATION 5%

$110 $115.5
EXAMPLE cont..

INFLATION 5%

$110 $115.5

TO MAINTAIN THE PURCHASING POWER ALSO,

THE REQUIRED RATE OF RETURN HAS TO BE
INCREASED
EXAMPLE cont..
 5% INCREASE IN INFLATION RATE WILL BE TAKEN AS INFLATION
PREMIUM
 INFLATION PREMIUM TO SUBSTITUTED TO THE FOLLOWING
EQATION
EXAMPLE cont..
 5% INCREASE IN INFLATION RATE WILL BE TAKEN AS INFLATION
PREMIUM
 INFLATION PREMIUM TO SUBSTITUTED TO THE FOLLOWING
EQATION

(1+r) (1+l) = (1+k)

EXAMPLE cont..
 5% INCREASE IN INFLATION RATE WILL BE TAKEN AS INFLATION
PREMIUM
 INFLATION PREMIUM TO SUBSTITUTED TO THE FOLLOWING
EQATION

(1+r) (1+l) = (1+k)

Where
r = real rate of interest
l = expected rate of inflation
k = nominal (market) rate of interest
EXAMPLE cont..

100 (1.10) (1.05) = 115.50

THIS CONCEPT IS KNOWN AS FISHER EFFECT