Also known as Fisher Hypothesis, the Fisher’s Effect was a theory proposed by economist Irving Fisher. The theory states that the real interest rate of an investment is not affected by other monetary measures, such as nominal interest rate and expected inflation. The theory describes the relationship between the inflation rate and both nominal and real interest rates.
According to Fisher Hypothesis, the nominal interest rate is the difference between the real interest rate and the expected rate of inflation. It also states that an increase in real interest rate occurs with decreasing inflation rate and vice versa, unless the same rate of decrease occurs with nominal rates as with inflation.
Real Interest rate = Nominal Interest Rate – Inflation Rate
The concept of Fisher's Effect is used −
By central banks while formulating their monetary policies
By investors for measuring their portfolio returns
By the currency exchange markets
The Fisher Effect theory is used by the central banks to form their monetary theories. The central banks are often tasked with keeping inflation in the right range.
The need is to prevent the economy from going too large while the economy is expanding.
It is also important to keep a small amount of inflation intact to stop the economy from getting into a depression during times of recession.
The tool to control the monetary policy lies with the central banks and they do this by using the nominal rate changes.
By increasing the nominal interest rate and keeping the interest rate fixed, inflation can be brought down.
By doing the reverse, inflation can be increased.
It is helpful to know the returns on the investment beforehand because if inflation rates are more than the rates of return, the investors may not achieve their targets. Inflation impacts the rates of return on investment and so must be considered while investing.
For example, suppose an investor tends to buy government bonds that offer a rate of interest of 3%. So, at the end of the year, the investors will get INR 103 for each bond. However, if inflation is 4%, the goods are now worth INR 104, so there is a shortfall of INR 1 when the investor needs to make a purchase.
In currency markets, the Fisher effect is called the International Fisher’s Effect (IFE).
It shows the relationship between nominal interest rates and the spot exchange rates of their currencies.
Hence, if the nominal rates and the current exchange rate is known, the future exchange rate can be calculated.
So, it is apparent that the Fisher effect is a useful tool to calculate various instruments in the financial markets. Its validity and importance are undebatable within the financial fraternity.