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Breathtaking Facts about Fisher Effect

The article on the Fisher Effect - a concept used in Macroeconomics, which predicts the correlation between the real and the nominal interests rates.

The Fisher Effect 

What Is the Fisher Effect?

The Fisher Effect is a macroeconomic concept developed by the early American economist Irving Fisher (1867-1947) that predicts that the real interest rate is equal to the nominal interest rate minus the rate of inflation, and that in order to hold the real interest rate constant, the nominal interest rate must be adjusted by an amount equal to the rate of inflation. 

The importance of this prediction is that it suggests that over a long term period, changes in monetary control measures, such as adjustments in interest rates or the money supply, have no real effect on real interest rates or economic output. In order to understand the Fisher Effect (which should not be confused with the similarly-named International Fisher Effect, which deals with currency values and was also developed by Dr. Fisher), we need to understand two basic economic ideas: the difference between real and nominal interest rates, and the quantity theory of money.

Real and Nominal Interest Rates: Example

The nominal interest rate is the stated interest borne by any sort of investment instrument – a savings account, bond, interest on a loan, and so on. For example, if you were to purchase a 30-day certificate of deposit at 5% interest for $1,000, the nominal interest at the end of those 30 days would be $50. Because of price inflation, however, the new balance of $1,050 is worth less than that relative to the $1,000 it was worth 30 days ago. If the inflation rate is 2%, then the real value of the balance is $1,030 – 5% minus the 2% inflation rate equals 3%, which is the real interest rate.

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The Quantity Theory of Money

The quantity theory of money relates prices to the supply of money in the economy; as the supply of money increases, so do prices. The theory is expressed by a simple, well-known equation M x V = P x Y, where M represents the money supply, V represents “velocity” or the number of times in a specified period the money is exchanged for goods or services, P represents an overall price level in an economy, and Y represents economic output, i.e. the real GDP. The equation can also be written in a form in which growth rates are substitutes for whole values for the variables; it functions in much the same way in either form.

In the quantity theory, so long as the “velocity” of money and the economic output do not change, prices have to change according to the money supply. Over long periods, the velocity of money does, in fact, remain fairly constant. Economic output does change, but other parts of economic theory demonstrate that changes in economic output are attributable to technology and factors of production, not changes in the money supply. In other words, increases in economic output automatically increase the velocity of money by a corresponding amount, canceling these two factors out of the equation, or making them constant in relation to the M and the P.

Enter the Fisher Effect

Now we return to real and nominal interest rates. The constant (or if you prefer, equivalent) nature of the velocity of money and economic output over long periods of time is an indication that real interest rates do not change. Think of it this way: at any given point in time, a dollar purchases a dollar’s worth of goods or services. In a short term, of course, we notice the lag in the value of our dollar due to price inflation, but over a long period, the relative value remains approximately the same; prices go up, but so do wages and earnings on investments.

That long-term consistency is the Fisher Effect. As inflation progresses, nominal interest rates are adjusted upward to compensate and keep real interest rates more or less constant. It’s “more or less” constant because the effect is not a smooth curve. When interest rates are set, the anticipated rate of inflation is taken into account; in reality, the rate of inflation usually differs slightly in magnitude and rate of change, meaning that from one interest-setting period to the next, the nominal interest rate either lags or leads to a small degree with respect to the inflation rate. The effect, however, averages out over a long period.

The Fisher Effect in the context of the quantity theory of money also explains why efforts to stimulate an economy through adding money to the financial system – the so-called “quantitative easing” – usually has little to no effect. In theory, increasing the money supply increases the velocity of money; there is more money to spend, therefore, more exchanges of money occur. Thus, in the quantity theory equation, the left side of the equation, M x V, increases. If prices, P, on the right side of the equation do not immediately increase, or do not increase by a necessary amount, then in order for the equation to remain equal economic output, Y, must increase.

The problem with this thinking is that first of all, economic output has the slowest rate of change of the four variables; prices will always change more quickly, and that keeps the equation equal. Second, nominal interest rates affect the velocity of money; when inflation rises, nominal interest rates are raised according to the Fisher Effect, and when interest rates increase, the velocity of money decreases. Interest on loans, for example, is raised because lenders are very aware of their real interest rate, and act to prevent it from decreasing. When loan interest is higher, fewer loans are made. For investors, higher interest rates encourage maintaining investments and accessing new ones, rather than liquidating them and spending the money on something else; the net change in the value of V is then zero, or close to it.

The Fisher Effect is essentially an explanation for the relatively constant, cyclical nature of the economy over a long period of time. It is a fairly basic economic concept and can be seen in action if one looks at the economy from a historical perspective. It does not appear in the short term, which is perhaps why government economic managers seem to forget about it; if they would keep it in mind, however, they would realize that much of their effort towards “stimulating the economy” or “managing the exchange value of the currency” has no real impact and that their time might be better spent on other activities.