Fisher hypothesis

# Fisher hypothesis

Discussion

Encyclopedia
In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, the Fisher hypothesis (sometimes Fisher parity) is the proposition by Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...

that the real interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

is independent of monetary measures, especially the nominal interest rate. The Fisher equation
Fisher equation
The Fisher equation in financial mathematics and economics estimates the relationship between nominal and real interest rates under inflation....

is

This means, the real interest rate
Real interest rate
The "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...

() equals the nominal interest rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...

() minus expected rate of inflation (). Here all the rates are continuously compounded. For simple rates, the Fisher equation takes form of

If is assumed to be constant, must rise when rises.
Fisher Effect: The one for one adjustment of the nominal interest rate to the expected inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...

.

To understand the relationship between money, inflation and interest rates it is important to understand nominal interest rate and real interest rate. The nominal interest rate is the interest rate you hear about at your bank. If you have a savings account, for instance, the nominal interest rate tells you how fast the number of dollars in your account will rise over time. The real interest rate corrects the nominal rate for the effect of inflation in order to tell you how fast the purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...

of your savings account will rise over time. An easy estimation of the real interest rate is the nominal interest rate minus the expected inflation rate (Note that this estimate is unwise when looking at compounded savings.)
Real interest rate= Nominal Interest Rate - Expected Inflation Rate

Nominal Interest Rate= Real interest Rate + Expected Inflation Rate

If inflation permanently rises from a constant level, let's say 4%/yr., to a constant level, say 8%/yr., that currency's interest rate would eventually catch up with the higher inflation, rising by 4 points a year from their initial level. These changes leave the real return
Continuously Compounded Nominal and Real Returns
-Nominal return:Let Pt be the price of a security at time t, including any cash dividends or interest, and let Pt − 1 be its price at t − 1. Let RSt be the simple rate of return on the security from t − 1 to t...

on that currency unchanged. The Fisher Effect is an evidence that in the long-run, purely monetary developments will have no effect on that country's relative prices.

The International Fisher Effect
International fisher effect
The International Fisher effect is a hypothesis in international finance that says that the difference in the nominal interest rates between two countries determines the movement of the nominal exchange rate between their currencies, with the value of the currency of the country with the lower...

predicts an international exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

drift independent of inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

- that is, entirely based on the respective national nominal interest rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...

s. (Though differential real rates will give the same exchange rate drift if inflation is internationally harmonized.)