Final answer:
The Fisher Effect explains the relationship between real rates, inflation rates, and nominal rates, and how changes in inflation can affect interest rates. Lenders demand higher nominal interest rates to compensate for the loss in purchasing power caused by inflation, while the real interest rate remains relatively stable.
Step-by-step explanation:
The Fisher Effect is defined as the relationship between real rates, inflation rates, and nominal rates. It explains how changes in inflation can affect nominal interest rates and real interest rates.This economic theory posits that the nominal interest rate is the sum of the real interest rate and the inflation rate. This concept is essential when considering the rate of return on investments like bonds, where the real interest rate is adjusted for inflation and you consider potential risk factors like the default risk premium and interest rate risk premium.
When there is inflation, the purchasing power of money decreases over time. To compensate for the loss of purchasing power, lenders demand higher nominal interest rates. However, the real interest rate (nominal interest rate minus inflation rate) remains relatively stable.
For example, if the nominal interest rate is 5% and the inflation rate is 2%, the real interest rate is 3%. This means that lenders are receiving a 5% return on their investment, but the purchasing power of the money they receive is only increasing by 3% due to inflation.