Final answer:
The Fisher Effect states that if the expected inflation rate increases, all else being the same, the nominal interest rate will also increase to maintain the expected real interest rate.
Step-by-step explanation:
According to the Fisher Effect, if the expected inflation rate increases, then all else being the same, the nominal interest rate will increase.
This is because the nominal interest rate is composed of the real interest rate plus the expected inflation rate. When people expect higher inflation, lenders demand higher nominal interest rates to compensate for the decreased purchasing power of the money when it is repaid.
Therefore, when inflation is expected to rise, the nominal interest rate will increase to ensure that the real interest rate remains constant, barring any other economic changes.
For example, if the current nominal interest rate is 7% and the rate of inflation is 3%, the real interest rate is 4%. If expected inflation increases, let's say from 3% to 5%, then the nominal interest rate would need to rise to 9% for the real interest rate to remain at 4%.
If lenders did not raise the nominal interest rate in response to rising inflation expectations, the real rate of return on loans would decrease. Overall, an increase in expected inflation leads to an increase in nominal interest rates to maintain lenders' expected real returns.