Question

Describe the long-run relationship between money growth and inflation. How does the long-run growth of income affect this relationship? Use the Fisher equation to describe the long-run relationship between money growth and nominal interest rates.

Answer 1

The Fisher equation is a concept in economics that describes the relationship between nominal and real interest rates under the effect of inflation. The equation states that the nominal interest rate is equal to the sum of the real interest rate plus inflation.

The Fisher equation is often used in situations where investors or lenders ask for an additional reward to compensate for losses in purchasing power due to high inflation.

The concept is widely used in the fields of finance and economics. It is frequently used in calculating returns on investments or in predicting the behavior of nominal and real interest rates. One example is when an investor wants to determine the actual (real) interest rate earned on an investment after accounting for the effect of inflation.

One particular significance of the Fisher equation is related to monetary policy. The equation reveals that monetary policy moves inflation and the nominal interest rate together in the same direction. On the other hand, monetary policy generally does not affect the real interest rate.

American economist Irving Fisher proposed the equation.

Fisher Equation Formula

The Fisher equation is expressed through the following formula:

(1 + i) = (1 + r) (1 + π)

Where:

i – the nominal interest rate

r – the real interest rate

π – the inflation rate

However, one can also use the approximate version of the previous formula:

i ≈ r + π

Fisher Equation Example

Suppose Sam owns an investment portfolio. Last year, the portfolio earned a return of 3.25%. However, last year’s inflation rate was around 2%. Sam wants to determine the real return he earned from his portfolio. In order to find the real rate of return, we use the Fisher equation. The equation states that:

(1 + i) = (1 + r) (1 + π)

We can rearrange the equation to find real interest rate:

Therefore, the real interest rate, or actual return on investment, of the portfolio equals:

The real interest that Sam’s investment portfolio earned last year, after accounting for inflation, is 1.26%.