Fisher Effect

7 Key excerpts on "Fisher Effect"

• 

  eBook - PDF

  Economics for Investment Decision Makers

  Micro, Macro, and International Economics

  • Christopher D. Piros, Jerald E. Pinto(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  However, there might be some short-run effects; confused people might buy too little sugar, and some people might go on crash diets! But ultimately people would adjust; in the long run, the change wouldn’t matter. There is a clear parallel here with the theory of money neutrality. Doubling the prices of everything—halving the value of a currency—does not change anything real. This is because, like kilograms, money is a unit of account. However, halving the value of a currency could affect real things in the short run. There are two points worth making with regard to money neutrality. First, although the simple kilogram analogy does suggest that money should not affect real things in the long run, as the British economist Keynes said: “In the long run we are all dead.” In practice, it is very difficult for economists to be sure that money neutrality holds in the long run. And second, we must assume that monetary authorities do believe that the money supply can affect real things in the short run. If they did not, then there would be almost no point to monetary policy. 2.1.7. The Fisher Effect The Fisher Effect is directly related to the concept of money neutrality. Named after the economist Irving Fisher, the Fisher Effect states that the real rate of interest in an economy is Chapter 7 Monetary and Fiscal Policy 345 stable over time so that changes in nominal interest rates are the result of changes in expected inflation. Thus, the nominal interest rate (R nom ) in an economy is the sum of the required real rate of interest (R real ) and the expected rate of inflation (π e ) over any given time horizon: R nom ¼ R real þ π e ð7-3Þ According to money neutrality, over the long term the money supply and the growth rate in money should not affect R real but will affect inflation and inflation expectations. The Fisher Effect also demonstrates that embedded in every nominal interest rate is an expectation of future inflation.

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  The Life Cyclists

  Fisher, Keynes, Modigliani and Friedman

  • C. Read(Author)
  • 2011(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Unfortunately, some of the most significant economic variables are in nominal terms. For instance, when Fisher modeled how consum- ers respond to the prevailing interest rate, the return on their savings was measured by the nominal, or inflation-unadjusted, interest rate, perhaps as published by the bank. Fisher was able to incorporate into his analysis a simple and intuitive adjustment that would allow him to remove the distorting effect of inflation from published interest rates. Inflation is measured as the proportional increase in prices, usually over one year. It is assumed that consumers will allot their income and wealth between two periods with the expectation that their income in each period can purchase consumption as they had planned. However, if inflation sets in, the income they assigned to purchase future con- sumption is able to purchase less. Fisher modeled the effect of inflation on future consumption. Let the symbol p represent the rate of price increases over the year. If the consumer sets aside savings of S for the next period consumption, and if these savings earn a nominal (posted) interest rate i, then the consumer will have an amount S(1 i) available for consumption of goods that will cost (1 p) times the amount they would command in the previous period. Without such inflation, a real interest of r would permit con- sumption of S(1 r) in the next period. We can use this logic to deduce the relationship between nominal interest rates and real interest rates: S(1 i)/(1 p) S(1 r) or (1 i)/(1 p) S(1 r) Multiplying through by (1 p) gives: (1 i) (1 r)(1 p) Further multiplying through the parentheses yields: 1 i 1 r p r p If the inflation rate π is small, the above expression reduces to: r i p In other words, the real or inflation-adjusted earnings on savings are approximately equal to the nominal interest rate i less the inflation rate p.

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  Handbook of Monetary Policy

  • Jack Rabin(Author)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  4 As indicated before, the federal funds rate is used as a measure of the stance of monetary policy. Thus a monetary policy action is defined as a change in the funds rate, and a monetary policy strategy is defined as the reaction function that would lead to policy actions. The Fisher relation for interest rates provides a convenient framework within which effects of policy actions can be described. The Fisher relation is

  B

  R t

  = r

  r t e

  +

  p ˙

  t e

  ,

  (1)

  where BR

  t

  is the bond rate,

  r

  r t e

  is the expected long real rate, and

  p ˙

  t e

  is the expected long-term inflation rate. Equation (1) relates the bond rate to expectations of inflation and the real rate.

  The Fisher relation indicates that policy actions could conceivably affect the bond rate by altering expectations of inflation, the real rate, or both. Since policy actions may not always move the real rate and inflation components in the same direction, the near-term responses of the bond rate to such actions cannot be determined a priori. Much may depend upon the nature of the strategy being pursued by the Fed. Goodfriend (1993) discusses three different strategies that may lie at the source of interaction between the bond rate and the funds rate. Consider, first, pure cyclical strategies in which the Fed routinely raises (lowers) the funds rate in response to cyclical expansions (downturns) without attempting to affect the current trend rate of inflation expected by the public. Under that strategy, a funds rate increase will tend to raise the bond rate by raising current and expected future short real rates (i.e., by raising the

  r

  r t e

  component in [1]). This cyclical comovement is short run in nature.

  The second strategy discussed by Goodfriend considers the response of the Fed to an exogenous change in the trend rate of inflation. If the trend rate of inflation increases, the bond rate automatically moves with inflation (equation [1]). The Fed may choose to keep the short real rate steady and will therefore move the funds rate in line with the rising or falling inflation rate. In this case the bond rate comoves with the funds rate because the Fed is responding to changing inflation in a neutral fashion. I refer to this source of comovement as long run in nature.

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  Taxation, Inflation, and Interest Rates

  • INTERNATIONAL MONETARY FUND(Author)
  • 1984(Publication Date)
  • INTERNATIONAL MONETARY FUND

    (Publisher)

  Second, it clearly shows that the measured impact on interest rates of all explanatory variables is conditional on the tax rate, τ. Since that rate may vary over time, it suggests a reason for changes over time in the fit of many interest rate equations. Finally, the derivation of equation (10) makes clear the theoretical basis for a negative relationship between expected inflation and the expected after-tax real rate. 13 The impact of expected inflation on the nominal interest rate reflects a combination of four factors: (1) the Fisher Effect, whereby the nominal interest rate rises by the full amount of a rise in expected inflation; (2) the tax effect, whereby the nominal interest rate must rise by more than the rise in expected inflation to maintain a constant expected after-tax real return; (3) the Mundell-Tobin effect, captured in equations (7) and (8), whereby a rise in expected inflation decreases equilibrium real cash balances, in turn increasing the steady-state level of flow savings owing to the real balance effect, with equilibrium being restored by means of a lower after-tax real interest rate, which raises investment to the higher level of savings; and (4) the Feldstein-Summers effect, whereby a rise in anticipated inflation depresses expected after-tax profits and causes investment to fall. In sum, tax effects move the coefficient above unity, while the Mundell effect and the Feldstein-Summers effect both push it below unity. Typical parameter values for τ and λ 1 indicate an expected value of 0.75 for the coefficient describing the impact of expected inflation on the nominal interest rate. 14 Even though tax effects by themselves tend to push the coefficient above unity, the combined depressing impact of the Mundell effect and the Feldstein-Summers effect may result in a net impact below unity

  Sign up to read

  Learn more about book
• 

  eBook - ePub

  The Money Illusion

  Market Monetarism, the Great Recession, and the Future of Monetary Policy

  • Scott Sumner(Author)
  • 2021(Publication Date)
  • University of Chicago Press

    (Publisher)

  money neutrality. Money is neutral if changes in nominal variables have no impact on real variables. If money is neutral, then an increase in the money supply does not impact the public’s real money demand—rather, it shows up as inflation. If money is neutral, then an increase in inflation does not affect the real interest rate—rather, it shows up as a one-for-one rise in nominal interest rates. And if money is neutral, then an increase in inflation has no impact on your real wage rate—rather, it gets passed along one-for-one as a nominal pay raise.

  We’ve already seen that the quantity theory of money is not precisely true, at least in its simplest form. An X% rise in the money supply doesn’t always lead to an X% rise in the price level. For similar reasons, none of the other theories relating real, nominal, and price-level variables are exactly true. The QTM, however, was shown to be useful in certain contexts, particularly for high-inflation countries. The same is true of all the other related theories—including some we have not even considered yet, such as purchasing power parity: they work best when countries experience high rates of inflation for a prolonged period of time.

  The Fisher Effect is most noticeable at high inflation rates, when it completely dominates changes in the real interest rate. Because real interest rates are usually fairly close to zero, a persistent inflation rate of 40% per year will lead to very high nominal interest rates—also close to 40% per year. The bigger the swings in inflation, the more dominant inflation becomes as a determinant of nominal interest rates. But when inflation is stable, as when a central bank targets it at 2%, then changes in nominal interest rates tend to reflect changes in the real interest rate, with fluctuations in inflation playing only a minor role. That has been the US experience since about 1991.

  To better understand interest rates, let’s consider an economy with no inflation and then add in inflation and see what happens. Figure 5.2 shows the loanable funds market. Let’s say the supply of loanable funds is upward-sloping, as higher interest rates induce savers to supply more loanable funds to banks and bond issuers. Now consider demanders of loanable funds. They might want to build a new project or buy a house. The higher the cost of the loan, the lower the quantity demanded. In a world where no inflation is expected, the nominal interest rate would equal the real interest rate—3%, in figure 5.2

  Sign up to read

  Learn more about book
• 

  eBook - PDF

  Global Finance and the Macroeconomy

  • A. Makin(Author)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Next, different forms of time varying Financial Flows, Interest Rates and Exchange Rates 87 risk including credit risk and country risk reveal how interest risk , premia arise. The approach then shows how changing exchange rate expectations can further in¯uence international borrowing and lending behaviour and hence cross-border interest differentials. 5.1.1 The Fisher Effect and UIP The accounting and behavioural relationships that link the nominal interest rate of a small open economy to the world interest rate via international ®nancial ¯ows, in¯ation rates and exchange rate expectations are i  (5.1) i r r i  i    (5.2) r i i r  (5.3) Y± C(i) S(i) L(i); S i > 0, L i > 0 (5.4) I I i;  B i;  ; I i < 0, I  > 0 (5.5) B(i) ± L(i) CAB B  (i; i  ); B  < 0, B  i  < 0 (5.6) i à e t 1  e t E (5.7) e t à      E (5.8)   à ) B  i; i  ; ;   L  i; i  ;  , E (5.9)  where i r is the real domestic interest rate; i r is the exogenous real world interest rate; i  is the nominal world interest rate; i is the nominal domestic interest rate;  is expected domestic in¯ation;   is expected world in¯ation; Y is the small economy's given national income; C is its domestic consumption expenditure; S is domestic saving; L is domestic lending; I is real domestic investment;  is real domestic 88 Global Finance and the Macroeconomy investment opportunities; CAB is the current account balance; B is the domestic demand for funds; B  is the external borrowing requirement; E à is expected currency depreciation; e t 1 and e t are spot exchange rates at times t 1 and t;  is domestic in¯ation in excess of world in¯ation; and L  is foreign lending. Consistent with the small-country variant of the intertemporal open economy model, domestic borrowers face a domestic real interest rate,  i r , set equal to the exogenous world interest rate, i r , in initial equilibrium as speci®ed in equation (5.1).

  Sign up to read

  Learn more about book
• 

  Available until 4 Dec |Learn more

  Monetary Economics

  • Jagdish Handa(Author)
  • 2002(Publication Date)
  • Routledge

    (Publisher)

  section 20.12 presents the empirical findings of two studies to illustrate applications of the liquidity preference and loanable funds theories.

  Given the common or underlying macroeconomic rate of interest as determined in this chapter, the next chapter will examine the time and the risk aspects of the interaction among the various interest rates in the economy. The main focus of that chapter will be on the term structure of interest rates.

  20.1 NOMINAL AND REAL RATES OF INTEREST

  The rate of interest that is charged on loans in the market is the market or nominal rate of interest . This has been designated by the symbol r . If the rational lender expects a rate of inflation πe , he has to consider the real rate of interest that he would receive on his loan. In perfect capital markets, the real rate equals the nominal rate minus the expected loss of the purchasing power of money balances through inflation, so that the expected real rate of interest r re equals:

  Equation (1) was proposed by Irving Fisher and is known as the Fisher equation. The real value of the rate of return that the lender would actually – ex post – receive from his loan is the actual real rate of interest (r r ), which is given by:

  where:

  r	nominal rate of interest
  r r	actual (ex post ) real rate of interest
  r re	expected real rate of return
  π	actual rate of inflation
  πe	expected rate of inflation

  If the actual rate of inflation is imperfectly anticipated, then r r would differ from r re and may or may not be positive. However, the rational expectations hypothesis implies that the error in expectations would only be random and uncorrelated with information available at the time the expectations are formed.

  In (1), on the interaction between the real rate of interest and the expected rate of inflation, Mundell (1963) argued that increases in the expected rate of inflation will cause a reduction in the demand for real balances, which will lower the real rate of interest, as can be seen through the use of the IS-LM analysis. Tobin (1965) argued that such a reduction in the demand for real balances will increase the demand for real capital and consequently lower its productivity and the real rate of interest. The impact of higher expected inflation on the real rate of interest is often called the Mundell-Tobin effect.

  Sign up to read

  Learn more about book