Fisher Effect: Explanation, Formula, Example, Applications

The Fisher Effect is an economic theory that describes the relationship between nominal interest rates, real interest rates, and expected inflation. It suggests that nominal interest rates adjust in response to changes in expected inflation to maintain real interest rates. Understanding the Fisher Effect empowers investors to make well-informed choices regarding their investment portfolios, allowing them to factor in how inflation influences their investment returns.

Table of Content

• What is the Fisher Effect?
• Fisher Effect Formula
• Example: How Can the Fisher Effect Help In Retirement Planning?
• Applications of Fisher Effect

What is the Fisher Effect?

Fisher Effect Definition: The Fisher Effect is a financial concept that helps us understand the relationship between interest rates and inflation. In simpler terms, it tells us how interest rates and the cost of living are connected.

Let's understand it through a real-life example:

Imagine you plan to invest in a fixed deposit. The bank offers you an interest rate of 6% annually for a given year. That's the nominal interest rate, the rate you see advertised.

During that year, you have noticed that the prices of goods and services in India, like food, clothing, and rent, have been increasing. This is inflation, and it erodes the purchasing power of your money.

Suppose the inflation rate in India for that year is 4%, meaning, on average, things are getting 4% more expensive.

So, if you put your money in that fixed deposit, you will earn 6% interest on your investment. But because of the 4% inflation, the things you could buy at the beginning of the year now cost 4% more at the end of the year.

In other words, your money's real purchasing power has only increased by 2% (6% - 4%). This 2% is the real interest rate, which is the actual return you have earned on your investment after considering the impact of inflation.

The Fisher Effect teaches that you must earn an interest rate higher than the inflation rate to grow your money and keep up with increasing prices. Otherwise, your money won't be able to buy as much in the future, and its real value will shrink over time.

Check out this video to understand the Fisher Effect in more detail.

Source - Marginal Revolution University (YouTube)

Fisher Effect Formula

The Fisher Effect formula is a financial and economic equation that relates nominal interest rates, real interest rates, and expected inflation rates. It is expressed as follows:

Real Interest Rate (Fisher Effect) = Nominal Interest Rate - Expected Inflation Rate

Where,

Real interest rate = The actual purchasing power of money and is the rate of return adjusted for inflation. It is also considered the rate of interest an investor or lender receives after accounting for the erosion of their purchasing power due to inflation.

Nominal interest rate = The actual interest rate observed in the market or the interest rate stated on a financial instrument (such as a bond or a savings account).

Expected inflation rate = The anticipated rate at which prices are expected to increase in future.

Example: How Can the Fisher Effect Help In Retirement Planning?

Suppose you will be retiring after 25 years from today. You currently have a diversified investment portfolio that generates an average annual return of 8%. 

However, you know India has historically experienced an average inflation rate of 5% per year. Using the Fisher Effect, you can assess how your investment returns might translate into actual returns and whether they will be sufficient to support your retirement lifestyle.

Calculate Real Interest Rate:

Nominal Interest Rate (Investment Return) = 8%

Expected Inflation Rate (India's historical average) = 5%

Real Interest Rate (Fisher Effect) = Nominal Interest Rate - Expected Inflation Rate

Real Interest Rate = 8% - 5% = 3%

After accounting for expected inflation in India, your real interest rate is 3%.

Calculate Future Value of Investments:

Let's assume you have Rs. 1,000,000 saved for retirement. Using the compound interest formula, you can estimate the future value of your investments in 25 years:

Future Value = Present Value x (1 + Real Interest Rate)^{Number of Years}

=> Rs. 1,000,000 x (1 + 0.03)²⁵

≈ Rs. 2,197,135

Your investments will grow to approximately Rs. 2,197,135 over the next 25 years, assuming an 8% nominal return and a 5% inflation rate.

Account for Inflation-Adjusted Income Needs:

Suppose your current annual expenses amount to Rs. 500,000. To maintain your purchasing power in retirement, you must adjust this amount for expected inflation in India. Using the Fisher Effect, you can estimate your future expenses:

Inflation-Adjusted Future Expenses = Current Expenses x (1 + Expected Inflation Rate)^{Number of Years}

Inflation-Adjusted Future Expenses = Rs. 500,000 x (1 + 0.05)²⁵

Inflation-Adjusted Future Expenses ≈ Rs. 1,339,412

So, you would need approximately Rs. 1,339,412 annually to maintain the same standard of living you have today. 

Applications of the Fisher Effect

The Fisher Effect has several practical applications in the finance industry, particularly in interest rates, investments, and inflation. Here are some real-life examples of how the Fisher Effect is applied:

1. Interest Rate Setting: Central banks and monetary authorities use the Fisher Effect to set nominal interest rates based on their inflation targets. For example, if a central bank has an inflation target of 2% per year, they may adjust nominal interest rates to ensure that real interest rates are aligned with their target.

1. Bond Pricing: Investors use the Fisher Effect to estimate the real return on bonds. When purchasing bonds with fixed nominal interest rates, investors factor in their expectations of future inflation to determine the actual return they will earn after adjusting for inflation.
2. Investment Decision-Making: Investors consider the Fisher Effect when making investment decisions. For instance, if they expect higher inflation in the future, they may seek investments that offer higher nominal returns to compensate for the eroding purchasing power of their money.
3. Loan Pricing: Financial institutions use the Fisher Effect to price loans and mortgages. Lenders consider the expected and real inflation rates when determining the interest rates they charge borrowers.
4. Currency Markets: In foreign exchange markets, traders use the Fisher Effect to assess the impact of interest rate differentials between countries. If one country has higher expected inflation than another, it can affect the relative strength of their currencies.
5. Portfolio Diversification: Investors diversify their portfolios based on the Fisher Effect. They may allocate their assets to various investments, including stocks, bonds, and commodities, to achieve a balance that accounts for inflation expectations.
6. Retirement Planning: Individuals planning for retirement use the Fisher Effect to estimate how inflation will affect their purchasing power during retirement.

In a Nutshell

The Fisher Effect is a fundamental economic concept that explains the importance of considering the impact of inflation on investment returns and financial planning. Individuals and investors can make more informed decisions about saving, investing, and retirement planning by calculating the relationship between nominal interest rates, real interest rates, and expected inflation. It is a valuable tool for safeguarding one's purchasing power over time, ensuring that financial goals are achieved in an environment where inflation is constant.