Fisher Hypothesis

In economics, the Fisher hypothesis (sometimes called Fisher parity or the Fisher Effect) is the proposition by Irving Fisher that the real interest rate is independent of monetary measures, especially the nominal interest rate. The Fisher equation is

This means, the real interest rate equals the nominal interest rate minus expected inflation rate . Here all the rates are continuously compounded. For simple rates, the Fisher equation takes form of

If is assumed to be constant, must rise when rises. Thus, the Fisher Effect states that there will be a one for one adjustment of the nominal interest rate to the expected inflation rate.

It is important to understand nominal interest rate and real interest rate. The nominal interest rate is the interest rate you hear about at your bank. If you have a savings account for instance, the nominal interest rate tells you how fast the number of dollars in your account will rise over time. The real interest rate corrects the nominal interest rate for the effect of inflation in order to tell you how fast the purchasing power of your savings account will rise over time. An easy estimation of the real interest rate is the nominal interest rate minus the expected inflation rate (Note that this estimate is unwise when looking at compounded savings.)

Real interest rate = Nominal Interest Rate - Expected Inflation Rate
Nominal Interest Rate = Real interest Rate + Expected Inflation Rate

If inflation permanently rises from a constant level, let's say 4% per year, to a higher constant level, say 8% per year, that currency's interest rate would eventually catch up with the higher inflation, rising by 4 points a year from their initial level. These changes leave the real return on that currency unchanged. The Fisher Effect is an evidence that in the long-run, purely monetary developments will have no effect on that country's relative prices.

It has been contended that the Fisher hypothesis may break down in times of both quantitative easing and financial sector recapitalisation. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=521402

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