Final answer:
The Fisher effect is used to determine the real interest rate by subtracting the inflation rate from the nominal interest rate. It helps understand the effective interest rate that borrowers pay and the return on investment that lenders receive after accounting for inflation. Unexpected deflation can raise the real interest payments for borrowers, impacting loan repayment and the economy.
Step-by-step explanation:
The Fisher effect is used to determine the real interest rate, which is the nominal interest rate minus the rate of inflation. It helps to understand the effective interest rate that borrowers pay or the return on investment that lenders receive after adjusting for inflation. For example, if the nominal interest rate is 7% and the rate of inflation is 3%, then the real interest rate is 4%. On the other hand, if there is deflation of 2%, then the real interest rate would be 9%.
The Fisher effect is important because it shows how changes in inflation can impact lenders and borrowers. When there is unexpected deflation, it raises the real interest payments for borrowers, potentially leading to challenges in loan repayment and decreasing the net worth of banks. This can have broader effects on aggregate demand and the economy, potentially leading to a recession.
However, it is important to note that inflation can sometimes benefit borrowers. For example, if inflation rises after borrowing at a fixed interest rate, the real interest rate on the loan may become zero or even negative, meaning the borrower benefits from inflation while the lender suffers. This illustrates the impact of inflation on the redistribution of wealth and the importance of considering inflation when dealing with fixed interest rates.