We have prepared this Fisher effect calculator to help you understand the Fisher effect equation and its calculation. The Fisher effect is an economic theory developed to explains the relationship between nominal interest rate and real interest rate. This is a crucial concept to understand if you are an investor.

We wrote this article to help you understand what the Fisher effect is and how to calculate it using the Fisher effect formula. To help you understand this concept, we will also demonstrate some exemplary calculations. Let's start our discussion by understanding the Fisher effect definition.

What is the Fisher effect? The Fisher effect definition

The Fisher effect is defined as an economic theory that explains the relationship between the nominal interest rate and the real interest rate. Hence, to fully understand the Fisher effect equation, we need first to understand the nominal interest rate and the real interest rate.

The nominal interest rate is defined as the real interest rate plus the expected inflation. These are the interest rates you see on the market. For example, the interest rates on bank loans are considered the nominal interest rate. These are the interest rate that you pay at a point in time. The real interest rate is the nominal interest after stripping away the expected inflation. It represents the economic value of the interest rate.

The Fisher effect states the relationship between the real interest rate and the nominal interest rate, which we explained above. It also describes the relationship between money supply and real interest rate. We'll explain the details after the calculation.

How to calculate the Fisher effect?

Calculating the Fisher effect is actually an easy task. The Fisher equation calculator requires 2 inputs:

  • Nominal interest rate, e.g., 5%; and
  • Expected inflation, e.g., 3%.

The calculation of the Fisher effect only requires 3 steps:

  1. Determine the nominal interest rate

The nominal interest rate can be found everywhere. The most accessible proxy is to refer to the interest rate of a standard bank loan. In our example, the nominal interest rate is assumed to be 5%.

  1. Determine the expected inflation of your country

Every government publishes their Consumer Price Index (CPI) every month. This is generally assumed to be the expected inflation rate. For the U.S., you can find the inflation data through the U.S. Bureau of Labor Statistics.

The expected inflation in our example is 2%.

  1. Calculate the real interest rate using the Fisher effect formula

The last step is to calculate the real interest rate using the Fisher effect equation. The Fisher effect formula is shown below:

real interest rate = nominal interest rate - expected inflation

Thus, the real interest rate in our example is 5% - 2% = 3%.

You can of course use this Fisher equation calculator to obtain the same result in no time!

How do we interpret the Fisher effect?

Now that we've settled the calculation, let's look how to interpret the relationship:

  • The Fisher effect depicts the relationship between nominal interest rate and real interest rate. Indirectly, this shows the relationship between nominal interest rate and the money supply.

  • This means that the nominal interest rate will adjust according to the inflation to keep the real interest rate constant.

  • Assuming the real interest rate does not change, the Fisher effect shows that if the central bank increases the interest rate by 2%, the nominal interest rate will also increase by 2%.

FAQ

What is nominal interest rate?

The nominal interest rate is the interest rate before taking inflation into account. These are the interest rates you see on bank loans. The most impactful nominal interest rate is the Federal Reserve funds rate.

What is the real interest rate?

Real interest rate is defined as nominal interest rate minus by the expected inflation. It reflects the purchasing power of the interest paid. Hence, the real interest rate is always seen as the better metric as it reflects the economic reality.

What is inflation?

Inflation is a phenomenon where the purchasing power of a currency decreases over time. This is generally shown in the increase in the prices of items. Hence, over time, the amount you can buy with a unit of currency is less.

What is the difference between the Fisher effect and the International Fisher effect?

The Fisher effect depicts the relationship between the nominal interest rate and real interest rate. On the other hand, the International Fisher effect explains the changes in currency exchange rates using the difference in the interest rate of 2 countries.

Wei Bin Loo
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