The Fisher Effect describes the relationship between inflation and nominal interest rates. According to this theory, nominal interest rates (i.e., rates of return) are influenced by expected inflation. The Fisher Effect suggests that nominal interest rates will adjust in response to changes in expected inflation, in order to maintain a certain level of real interest rates.
To understand this concept, let's consider an example:
Suppose you are considering investing in a bond that offers a fixed nominal interest rate of 5% per year. At the same time, the expected inflation rate for the upcoming year is 2%.
According to the Fisher Effect, the nominal interest rate will incorporate the expected inflation rate to maintain a certain real interest rate. In this case, the real interest rate is the interest rate adjusted for inflation, which represents the actual purchasing power gained from the investment.
Applying the Fisher Effect, the nominal interest rate would be calculated by adding the expected inflation rate to the desired real interest rate. In this example, if the desired real interest rate is 3% (5% - 2% inflation), the nominal interest rate would be adjusted to 5% (3% real interest rate + 2% expected inflation).
Therefore, the Fisher Effect indicates that when inflation expectations increase, nominal interest rates are expected to rise to preserve the desired real interest rate. Conversely, if inflation expectations decrease, nominal interest rates are expected to decrease.
This relationship between inflation and rates of return helps investors and lenders account for the impact of inflation on their investments and adjust their expectations accordingly.