Finance:Fisher hypothesis

Short description: Correlation between the rate of interest and the rate of inflation

In economics, the Fisher hypothesis (sometimes called the Fisher effect) is the proposition by Irving Fisher that the real interest rate is independent of monetary measures, specifically the nominal interest rate and the expected inflation rate. The term "nominal interest rate" refers to the actual interest rate giving the amount by which a number of dollars or other unit of currency owed by a borrower to a lender grows over time; the term "real interest rate" refers to the amount by which the purchasing power of those dollars grows over time—that is the real interest rate is the nominal interest rate adjusted for the effect of inflation on the purchasing power of the loan proceeds.

The relation between the nominal and real rates is approximately given by the Fisher equation which is

[math]\displaystyle{ r = i - \pi^e. }[/math]

This states that the real interest rate ([math]\displaystyle{ r }[/math]) equals the nominal interest rate ([math]\displaystyle{ i }[/math]) minus the expected inflation rate ([math]\displaystyle{ \pi^e }[/math]). The equation is an approximation. The difference between this and the absolutely correct equation is very small unless either the interest rate or inflation is very high, or it is being applied over a long period of time. The accurate statement, expressed using continuous compounding, is

[math]\displaystyle{ 1+i =(1+r)\times (1+\pi^e) }[/math]

If the real rate [math]\displaystyle{ r }[/math] is assumed, as per the Fisher hypothesis, to be constant, the nominal rate [math]\displaystyle{ i }[/math] must change point-for-point when [math]\displaystyle{ \pi^e }[/math] rises or falls. Thus, the Fisher effect states that there will be a one-for-one adjustment of the nominal interest rate to the expected inflation rate. The implication of the conjectured constant real rate is that monetary events such as monetary policy actions will have no effect on the real economy—for example, no effect on real spending by consumers on consumer durables and by businesses on machinery and equipment.

Some contrary models assert that, for example, a rise in expected inflation would increase current real spending contingent on any nominal rate and hence increase income, limiting the rise in the nominal interest rate that would be necessary to re-equilibrate money demand with money supply at any time. In this scenario, a rise in expected inflation [math]\displaystyle{ \pi^e }[/math] results in only a smaller rise in the nominal interest rate [math]\displaystyle{ i }[/math] and thus a decline in the real interest rate [math]\displaystyle{ r }[/math]. It has also been contended that the Fisher hypothesis may break down in times of both quantitative easing and financial sector recapitalisation.

Related concept

The international Fisher effect predicts an international exchange rate drift entirely based on the respective national nominal interest rates. A related concept is Fisher parity.