# Fisher Effect Definition and Relationship to Inflation

> **Definition**
>
> The Fisher effect relates to nominal interest rates changing in response to fluctuations in inflation to keep the real interest rate stable.

## What Is the Fisher Effect?

The Fisher effect concerns the way that changes in the inflation rate (and expectations for inflation) influence nominal interest rates.

It is an economic theory created by American economist Irving Fisher to explain the effect inflation has on nominal rates and real interest rates.

Normally, the nominal interest rate equals the real interest rate plus an expected inflation rate.

Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.

### Key Takeaways

*   The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. 
*   The Fisher effect has been extended to the analysis of the money supply and international currency trading.
*   When the real interest rate is positive, it means the lender or investor is able to beat inflation.
*   When the real interest rate is negative, it means the rate charged on a loan or paid on a savings account is not beating inflation.

![Fisher Effect: An economic theory describing the relationship between inflation and both real and nominal interest rates.](https://www.investopedia.com/thmb/fBvYwyDgbEE4rlSUcYR5kf35lF0=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Fisher-effect-final-dfeba6063c124342a17bdb80b7417b48.png)

*The Fisher effect takes place in the long run and assumes constant real interest rates. — Investopedia / Lara Antal*

## Understanding the Fisher Effect

Fisher's equation shows that the real interest rate can be calculated by subtracting the expected inflation rate from the nominal interest rate. In this equation, all the provided rates are compounded.

The Fisher effect can be seen each time you go to the bank; the interest rate on a savings account is really the nominal interest rate.

For example, if the nominal interest rate on a savings account is 4% and the expected rate of inflation is 3%, then the money in the savings account is really growing at 1%.

The smaller the real interest rate, the longer it will take for savings deposits to grow substantially when observed from a purchasing power perspective.

> **Fast Fact**
>
> Countries will closely monitor the Consumer Price Index (CPI) when determining inflationary measures.

## Nominal Interest Rates and Real Interest Rates

Nominal interest rates reflect the financial return you get when you deposit money. For example, a nominal interest rate of 10% per year means that you'll receive an additional 10% of your deposited money in the bank.

Unlike the nominal interest rate, the real interest rate considers purchasing power in the equation.

With the Fisher effect, the nominal interest rate is the provided actual interest rate that reflects the monetary growth padded over time to a particular amount of money or currency owed to a financial lender. Real interest rate is the amount that mirrors the purchasing power of the borrowed money as it grows over time.

## Importance for the Money Supply

The Fisher effect is more than just an equation: It shows how the money supply affects the nominal interest rate and inflation rate in tandem.

For example, if a change in a central bank's monetary policy pushed the country's inflation rate to rise by 10 percentage points, then the nominal interest rate of the same economy would follow suit and increase by 10 percentage points.

In this light, it may be assumed that a change in the money supply will not affect the real interest rate, as the real interest rate is the result of inflation and the nominal rate. It will, however, directly reflect changes in the nominal interest rate.

> **Important**
>
> When one country has a higher nominal interest rate than another, the first country's currency should see depreciation against the second currency, as the first currency will also be experiencing a period of increased inflation.

## The International Fisher Effect

The [International Fisher effect (IFE)](https://www.investopedia.com/terms/i/ife.asp) is an exchange-rate model that extends the standard Fisher effect and is used in forex trading and analysis.

It is based on [present and future risk-free](https://www.investopedia.com/articles/economics/10/international-fisher-effect.asp) nominal interest rates, rather than pure inflation, and is used to predict and understand current and future spot currency price movements.

For this model to work in its purest form, it is assumed that the risk-free aspects of capital must be allowed to float freely between nations that comprise a particular currency pair.

The IFE was primarily used in monetary policy periods when interest rates were adjusted more frequently and in larger amounts.

With electronic trading and the advent of the retail [arbitrage](https://www.investopedia.com/terms/a/arbitrage.asp) trader, the inconsistencies between spot exchange rates are more visible and, thus, the inconsistency is more quickly noticed; the trade becomes too crowded to be significantly profitable.

However, the IFE, as well as additional methods of trade confirmation, can be incorrectly assessed. In this case, even though there may not be an empirical advantage to a trade, there may be a psychological one if the spot predictions have been incorrectly assessed and acted upon.

## Explain Like I'm 5

A nominal interest rate is the rate you pay for a financial service, such as a loan, or the rate you receive as a return on an investment after accounting for inflation.

The Fisher Effect states that the nominal interest rate minus the expected inflation rate is the real interest rate on that investment, loan, or other interest-bearing account or asset.

Essentially, it means that by calculating the effect, you should be able to observe whether the rate being charged or earned is beating inflation or not.

## What Does the Fisher Equation Tell Us?

The Fisher Effect attempts to determine whether an interest-bearing asset is beating inflation. Inflation erodes purchasing power over time, so if a rate does not return enough to account for inflation, the asset is losing purchasing power in the long run.

## What Does the Fisher Effect Primarily Emphasize?

The Fisher Effect aims to explain why lenders raise rates when inflation is rising. However, in most cases, lenders raise rates when inflation is rising too quickly because the Federal Reserve increases its administered rates to slow down the economy.

## What Are the Assumptions of the Fisher Effect?

The Fisher Effect assumes that financial markets are efficient and people have rational expectations.

## The Bottom Line

The Fisher effect is a theory describing the relationship between real and nominal interest rates, and inflation.

The theory states that the nominal rate will adjust to reflect the changes in the inflation rate in order for products and lending avenues to remain competitive.

It is a theory that is sometimes applied to currency pairs in order to profit from price discrepancies through a trading method called arbitrage.