finance   Fisher Equation

Definition of Fisher Equation

Fisher equation is implemented in financial mathematics and economics to project the accord between nominal interest rate and real interest rate depending on inflation. This equation is dedicated on the name of acclaimed American economist, Irving Fisher, who has gained his popularity for his brilliant works in theory of interest.

  • The fisher effect is used every you go to the bank, and the interest rate that investor has in his account is counted as nominal interest rate.
  • The fisher effect which is interpreted in Fisher equation describes that the real interest rate equals the nominal interest rate minus the expected inflation rate. As the relation is stated, real interest rate goes down when inflation is increasing, unless the nominal interest rate increases at the same as inflation is rising.

In mathematical terms, the equation goes like this,

real rate of interest + inflation rate = nominal rate of interest. 

Books on Fisher Equation

Book 1:

Monetary Economics, 2nd Edition By Jagdish Handa (published by Routledge, 2008)

Book 2:

Consumer Price Index Manual: Theory and Practice (EPub) By International Monetary Fund (published by International Monetary Fund, 2004)

How Fisher Equation works?

Here a few practical usage of this finance concept in practical life, with the given two examples the fundamentals of Fisher equation can be described,

  • This equation can be administered either ex-ante, meaning before or ex-post, meaning after, for the analysis of a loan, for example, three-month Treasury Bill, which is widely used, the rates of the Treasury Bill are set every Monday for the next three months. Let’s say that the nominal interest rate can be described as an observable ex-ante variable. When the Fisher equation is implemented,

it = rt+1 + πt+1, which comes to the conclusion that an ex-ante variable as the sum of two ex-post variables.

  • Suppose the nominal interest rate on the principle is 4%, and the investor expect the inflation rate would go to 3%, and then it is seen that the amount of money that saving account has id directed to the growth of 1%.

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