Economics Terms A-Z - Los términos más importantes de economía.

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Economics Terms A-Z

Fisher Effect

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The Fisher Effect in economics refers to the idea that inflation and expected inflation affect nominal interest rates, for example those offered by banks for savers or borrowers. Importantly, it implies that consumers’ inflation expectations are reflected in the nominal interest rate, which prevents the real interest rate from changing.

This means that individuals’ inflation expectations changing causes the nominal interest rate to fluctuate in parallel, keeping the real interest rate the same.

Roughly speaking, a typical nominal interest rate, for example the interest rate offered by a bank for a loan, will reflect the real interest rate (the cost of borrowing the money), plus any expected changes in inflation. This is because the bank will want to compensate for the anticipated loss in spending power (inflation) of the money it is lending out, when it receives payment back a year later.

Alternatively, the Fisher Effect can be stated in terms of actual inflation. In this case, nominal interest rates change to match the real level of inflation. This again means that real interest rates are stable. This case rests on slightly different assumptions, but students may encounter either version and the takeaways are largely the same.

The effect is named after American economist Irving Fisher, who first proposed it. The idea of the Fisher Effect is similar to the economic theory of monetary neutrality in that real economic outcomes are said to be unaffected by “nominal” variables (like, in this case, the nominal interest rate).

Defining the Fisher Effect again, with math!

It’s important to understand the difference between nominal and real interest rates in order to study the Fisher Effect. For more on this difference, see the article on interest rates.

The Fisher Effect states that the nominal interest rate is approximately equal to the real interest rate plus the expected future inflation rate. It can be easily described mathematically as follows: ir + 𝜋e, where i is the nominal interest rate, r is the real interest rate, and 𝜋e is the expected rate of future inflation. It’s important to keep in mind that this equation is only approximate.

From this equation, it’s clear to see one of the core concepts of the Fisher Effect: that inflation expectations can change nominal interest rates. This makes sense. If rational economic agents expect high inflation, they will adjust the terms of their financial agreements. For example, a bank will set the conditions for loans while taking into account the (expected) decreased purchasing power of money by the time of repayment.

Alternatively, the effect can be expressed as ri – 𝜋e. This is the same equation rearranged, showing more clearly that the real interest rate is defined by the nominal interest rate and the expected rate of inflation.

There is another version of the Fisher Effect that you may encounter that uses inflation directly instead of inflation expectations. To acquire this formula, simply replace 𝜋e from above with 𝜋. In this version of the Fisher Effect, agents in the economy are able to perfectly adjust the nominal interest rate at the same time as inflation changes to achieve the desired real interest rate.

Students may come across another, even more advanced formulation of the Fisher Effect as well (this equation is considered more accurate, however it is still an approximation):

(1+i) ≈ (1+r) * (1+𝜋)

In this formula, the real interest rate r is typically held constant by assumption. This leads to the same result as above, where changes in inflation (𝜋) are mirrored by changes in nominal interest rates (i) to keep the real interest rate (r) steady.

Regardless of the specific equation used, the conclusions and implications of the Fisher Effect are the same. The main difference is that the assumptions powering the Fisher Effect are slightly different depending on whether actual or expected inflation is used.

Specifically, in order for the Fisher Effect to be true, economic agents must be rational and have enough information to accurately predict (or measure) the rate of inflation. Further, financial markets must be efficient.

These assumptions allow the nominal interest rate to mirror the (expected) inflation rate, preventing the real rate of interest from changing. But, if financial markets are inefficient or if economic agents lack information, the resulting frictions will cause the real interest rate to differ from the Fisher Effect equation.

Implications of the Fisher Effect

There are some important implications of the Effect to explore. First, if people expect a positive rate of inflation, then nominal interest rates will be higher than real interest rates. This means that the cost of borrowing money (which is the real interest rate) will be lower than what’s laid out in contracts (the nominal interest rate), and the benefit from saving or lending money will be lower as well. 

To see this, consider a scenario where a borrower takes out a $250 loan and must repay $20 one year after taking out the loan (i is 8%), while inflation is 5% over the course of that year. Since the purchasing power of money decreases by 5% over the year, $20 at the beginning of the year can only buy $19 worth of goods by the end of the year, since prices increased. Thus, although the nominal inflation rate (i) was 8%, the real interest rate (r) was only about 3%. You can verify this with the more precise version of the Fisher Effect equation above to find that r is roughly 2.89%.

Conversely, if people expect deflation, nominal interest rates will be lower than real rates. This causes the cost of borrowing money to be higher than what’s laid out in contracts, and the benefit from saving or lending to be higher than what’s written as well – if inflation behaves as expected.

Keep in mind that these are merely expectations of inflation. Actual “winners” and “losers” don’t emerge until inflation actually occurs. If inflation is higher than expected, the purchasing power of money declines more than expected over the period. This means that borrowers have to pay back less than expected in real terms and they are “winners”, while savers and lenders experience lower returns than expected and are “losers”. Meanwhile, if inflation is lower than expected, the opposite is true.

To return to our example above, if the borrower spent their $250 immediately, but six months later there is an unexpected period of intense inflation, such that prices have doubled by the end of the year, the $20 owed would now be worth only $10 in “old money”. In this scenario, the borrower would “win”. The bank would “lose” because the $20 they receive back would be worth less than the $19 they expected and had calculated into the nominal interest rate.

For more on winners and losers when inflation differs from expectations, the article on interest rates offers a more involved discussion.

The Fisher Effect has important implications for monetary policy, as well. Central banks play a crucial role in setting interest rates through their monetary policies (though they can’t directly control interest rates across the entire economy). The Fisher Effect suggests that central banks must consider inflation’s effect when setting nominal interest rates to target the desired real interest rate.

For example, suppose the central bank wishes the real interest rate target to be 5%, and inflation (or inflation expectations) is 2%. Then, the appropriate nominal interest rate to set according to the Fisher Effect equation is about 7%.

But, if inflation is -10% (a case of deflation), the appropriate nominal interest rate is actually roughly -5%! Clearly, it seems economically irrational for someone to accept a financial agreement with a negative rate of interest: why should a lender pay a borrower to borrow their money? This illustrates the “zero lower bound” problem that central banks may face when attempting to implement very low interest rates.

Evidence for the Fisher Effect in real life

If the Fisher Effect held (approximately) true at all times, then central banks could easily manage inflation by changing nominal interest rates. A lower nominal rate would lower inflation, and vice versa. Unfortunately, the Fisher Effect does not always appear to hold in the real world.

Over the years, economists have found mixed evidence for the existence of the Fisher Effect. Fredric Mishkin found that the Fisher Effect existed in the long term, but in the short term was negligible1,2. In 2018, Martín Uribe found that the Fisher Effect held true for temporary changes in the nominal interest rate, but when the nominal rate changed permanently, it actually led to inflation; the author dubbed this the “neo-Fisher Effect”3.

The fact that there is some limited evidence makes sense. It’s likely that the Fisher Effect mechanism is taken into account by rational economic agents – since they must account for inflation as they make financial agreements. But, we’ve also seen in history how central banks cannot completely control inflation with their monetary policy tools, which include nominal interest rate adjustments – just look at the financial market crash of 2008 that prompted the Great Recession.

The mixed evidence for the existence of the Fisher Effect suggests that policymakers should take the effect into account when designing policy, but should not be beholden to it, nor should they expect the economy to always behave as the Fisher Effect equation would predict.

Good to Know

The Fisher Effect has implications for the market for loanable funds; equilibrium in that market is determined partially by interest rates, after all.

According to the Fisher Effect, when inflation expectations rise, the nominal interest rate will rise with it just enough to perfectly offset any effect on real interest rates. Since equilibrium in the loanable funds market is dependent on the real interest rate, if the Fisher Effect holds, changes in inflation expectations and the nominal interest rate have no effect on the market for loanable funds.

But if the Fisher Effect does not hold, a change in inflation expectations can affect the market for loanable funds. Suppose that consumers expect inflation to increase in the future, but the nominal interest rate does not adjust to these new expectations quickly.

This will cause more people to seek borrowing in the short term, before the expected increase happens, and fewer people to save, despite no change (yet) in the interest rate. That’s because they expect the purchasing power of money to diminish in the future, and can take advantage of this by borrowing money and paying lower-than-expected repayments (in real terms).

This causes a rightward shift (increase) in the demand for loanable funds, and disequilibrium in the loanable funds market. Suddenly there is an excess demand for loanable funds, but a lack of supply to give out those funds (since borrowing became less expensive and lenders would reap a lower return). To restore equilibrium, the real interest rate must rise.

References

1: Mishkin, F. (1991). Is the Fisher Effect for Real? A Reexamination of the Relationship between Inflation and Interest Rates. https://doi.org/10.3386/w3632
2: Mishkin, F., & Simon, J. (1995). An Empirical Examination of the Fisher Effect in Australia. https://doi.org/10.3386/w5080 
3: Uribe, M. (2018). The Neo-Fisher Effect: Econometric Evidence from Empirical and Optimizing Models. https://doi.org/10.3386/w25089

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