Question

Use the bond demand and supply framework to explain the Fisher effect and why it occurs.

Answer 1

Fisher effect explains the relationship among the inflation rate, real interest rate and the nominal interest rate. As per the Fischer effect, real interest rates come down with increase in inflation rate in the economy. It is applied in the bonds market and demand and supply of bonds are affected by these interest rates and inflation. For example, when there is an expectation of rise in inflation, then firms will issue the bond as they want to reimburse the investors with inflated values (having less purchasing power), whereas the demand of bonds will come down as investors don’t want return with lower purchasing power. It happens due to the decrease in real interest rate and increase in inflation, setting a new equilibrium where bond prices come down, interest rate rises and more quantity of bond is sold in the market. It is illustrated in the following diagram. S1 and D1 is the market supply and demand before the rise in inflation, S2 and D2 is the market supply and demand after the rise in inflation.

It happens because bonds issuers want to payback with lower real purchasing power, but investors don’t want to buy the bonds with a lower real interest rates. So, a new equilibrium sets with a compromise between the demand and supply. Interest rate increases and the price of the bonds come down with increases in bond sales.