Describe how the Fisher Effect explains the interaction of expected inflation and changes in interest rates.

Describe how the Fisher Effect explains the interaction of expected inflation and changes in interest rates.

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Expert Solution

Given data:

· The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate.

· Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation

· Fisher effect is explaining the interaction of the expected inflation and change in interest rate by deriving between the relationship between real interest rates and nominal interest rates in which it is advocating that real interest rates will be equal to nominal interest rate after it is subtracted with the inflation.

Real interest rate= (nominal interest rate-expected inflation)

· Hence, it is trying to advocate that the expected inflation is already embedded into the nominal interest rate and it will have to be taken out in order to find out the real interest rate so real interest rate is more important.

· It can also be advocated that real interest rates will be falling when the inflation will be rising, and it will be rising when the inflation will be falling

Rahul Sunny answered 1 year ago

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