All That You Need To Know About Fisher Equation

Naturally, today studies become harder than ever before. Today students have to study many typical, hard, and complicated topics and subjects. Even those subjects are an essential part of their academics. Economics is one of the subjects that seems harder and typical to most of the students. Because economics contains so many typical and complicated concepts that are difficult to learn and understand for an average student.

The Fisher equation is one of the concepts of economics, which seems most difficult to understand to students. Fisher is the economist who is the designer of this equation. The Fisher equation is one of the essential concepts of economics that define the relationship between the real interest and nominal rate of interest at the time of the negative effects of inflation.  The concept contains many difficult things and formulas. Hence students always seem confused about the fisher equation. If you are also confused about the fisher equation then you came at the right place. Here we are going to discuss everything that you need to know about the fisher equation.

What is the Fisher Equation?

The Fisher equation is one of the most important concepts of economics. This equation clearly describes the relationship between the nominal interest rate and real interest rates during the major effect of inflation. The fisher equation shows that the nominal rate of interest is equal to the total sum-up of the real rate of interest and inflation.

The Fisher equation is mostly used in that situation when the lenders and investors demand some additional rewards as compensation to the losses in their purchasing power due to high inflation.

Finance and economics are the two major fields where the fisher equation is widely used. As we already discussed that the equation is used for predicting the behavior of real interest and nominal interest rates. Along with this, this equation is frequently used for predicting calculating returns on the investments. 

For example

When any investor desires to assess what is the real interest rate acquired by him on the investment, after accounting all the effects of inflation.

The formula of the Fisher equation

We can understand and express the fisher equation from the mentioned method or formula

(1 + i)  = (1 + r) (1 + π)

It is noteworthy that Here’

π –  Stands for the inflation rate

i –  Stands for the nominal interest rate

r –  Stands for the real interest rate

Therefore in simple words, the formula is 

 (1 + nominal interest rate) = (1 + real interest rate) * (1 + inflation rate)

Hence we can easily show the rough connection amidst the real rate of interest and the nominal rate of interest as mentioned-:

                          i ≈ r + π

Example of the Fisher Equation

Here is the example that can helpful for you to understand the fisher equation easily

Let’s suppose Ram owns a firm that has a real rate of return of 3.5 percent and at the same time expected inflation rate is 5.4 %. Therefore according to the fisher formula, you can calculate the approximate nominal rate of the returns of your firm as 0.035 + 0.054 = 0.089 (something around), or 8.9%. Hence, the main reason for substituting the value of the r and i in the fisher formula for the equation, (1 + i) = (1 + r) * (1 + Pi), the value for the nominal rate of interest is 9.1%.

What is the ”Inflation Rate”?

The inflation rate is a  scale or method of the price inflation that comprises the measurement of the annual percentage change in the CPI( consumer price index). Thus we can say that the inflation rate has a greater contribution to the growth of any economy because it calculates and harmonizes all the big or small increases in the general price index of goods at all levels. Without any doubt, every country must monitor the inflation rate from time to time, as the inflation rate can damage an economy variously.

What are the  ”Nominal Interest Rates and Real Interest Rates”

Nominal interest rate

The nominal rate of interest is used to show the financial return of the investor if he deposits some money in any bank. For example- ram deposits some money in the bank that offers a nominal rate of interest 20% annually. Now Ram will receive an additional 20% of the sum of money that he deposited in the bank.

Real Interest Rate

The real rate of interest is completely different from the nominal rate of interest. Because the real interest rate used to consider the purchasing power of an individual only.

The major basics of the ”Fisher Effect”

The fisher equation shows that we can take real interest rates, by subtracting the inflation rate from the ”nominal rate of interest”. You can easily understand it by an example.

Example

If ram has a savings account in a bank that offers a 5% nominal interest rate and at the same time the requisite rate of inflation is 4%. Then it means the saved money in the account is actually growing with the rate of 1% only. 

Important features of fisher equation

  • The fisher effect is one of the most essential concepts of economic theory. That is Generated by an economist named Irving fisher. That explains the relationship between both real and nominal rates of interest and inflation.
  •  The fisher effects also show that the real rate of interest is equal to the nominal rate, that minus from the expected inflation rate.
  •  Actually, the fisher effect has been extended for the analysis of the international currencies trading and the money supply curve.

Importance of fisher effect in Money Supply

The fisher effect is not just an economics equation. But it’s more than just an equation. The fisher effect shows how money supply directly affects the nominal interest rate and the inflation rate.

An Example

Let suppose with a sudden change in a central bank of a country would push the inflation rate of that country to rise by 10% percentage points. Then you can see that the nominal interest rate of that same country’s economy would follow suit and suddenly increases to 10% points as well. 

In this case, the assumption is that any transformations in the money supply curve will not affect the real interest rate. This means here it is assumed that the real interest rate is unaffected in the fisher effect.

Conclusion

We have mentioned all the important and relevant things that you need to know about the fisher equation. We hope that our blog will become helpful for you to better and well understand the fisher equation. Still, if you have any confusion about the fisher equation or any other relevant equation then don’t feel any hesitation to contact us at AustralianAssigment.com.
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