Fisher Effect
Inflation is soaring. In the United States, since prices started spiking in early 2021, food inflation has surged 22%. Eggs are up 87%, auto insurance has soared nearly 47% and gasoline is up 16%.
Generally speaking, most people have a negative impression of inflation. Inflation is associated with rising prices, currency depreciation, income pressure, and tragic events. However, is inflation always detrimental to everyone? Can inflation potentially benefit some in our society?
Let's imagine a scenario. Lin borrowed ONE THOUSAND DOLLARS from Luna at an interest rate of FIVE PERCENT per year for ONE year, which means that Lin will pay back Luna ONE THOUSAND FIFTY DOLLARS after one year.
Let’s say that we experience a THREE PERCENT inflation during the year, which means that an item worth ONE THOUSAND DOLLARS when Lin borrowed the money will be worth ONE THOUSAND THIRTY DOLLARS when Lin returns the money along with the interest.
Therefore, even if Luna is supposed to gain FIFTY DOLLARS out of this deal, the FIFTY DOLLARS interest that she received is partially offset by an overall increase in price levels throughout the society. In terms of purchasing power, Luna only received TWENTY DOLLARS in interest. In other words, even if the nominal interest rate is FIVE PERCENT, the real interest rate is TWO PERCENT. Lin benefitted by paying less real interest.
“What do you mean by ‘nominal’ and ‘real’ interest rates?”, you may ask. The nominal interest rate, well, is the nominal interest rate. It has not been adjusted for inflation. In real life, the interest rates for bank deposits, loans, and credit card payments are generally nominal interest rates. In contrast, the real interest rate is the actual interest rate. The actual interest rate here refers to the interest rate that take s into account how the value of the interest changes given inflation. In the scenario we just discussed, it is obvious that the nominal interest rate is FIVE PERCENT, and the real interest rate is two percent
But what is the relationship between inflation rate, nominal interest rate, and real interest rate? That’s where the Fisher Effect comes in.
The Fisher Effect is an economic hypothesis developed by economist Irving Fisher that explains the relationship between inflation and real and nominal interest rates. According to the Fisher effect, nominal interest rate equals real interest rate plus expected inflation rate. This is how people can benefit from inflation.
Let's return to the previous scenario. Lin borrowed ONE THOUSAND DOLLARS from Luna at an interest rate of FIVE PERCENT per year. Over the year, the inflation happens to be THREE PERCENT, so Lin paid only TWO PERCENT of real interest, thus getting a bonus out of the deal.
In the previous example, Luna didn’t consider the potential impact of inflation on interest. Obviously, in the real world, people are smarter. When bankers lend money, they would have a “real interest rate” that they want to gain out of the deal in their mind. Then, to offset inflation, they would add the inflation rate onto the real interest rate to get the nominal interest rate that they will actually charge. Of course, they can’t know the exact inflation rate in advance, so they can only go with a predicted inflation rate. Consequently, if inflation is higher than expected, the real interest rate would be lower, and the banker would be at a loss because they receive less real interest. In contrast, if inflation is lower than expected, the real interest rate would be higher, and the banker would be at a benefit because they receive more real interest.
The next time Luna lends money to Lin, Luna becomes smarter with the knowledge of the Fisher Effect in mind. She wants to get FIVE PERCENT real interest from the deal, and she forecasts the inflation rate to be at THREE PERCENT. So, Luna would offer Lin an EIGHT PERCENT interest rate, considering inflation. If the inflation rate is higher than the expected THREE PERCENT, say FOUR PERCENT, Luna would only get FOUR PERCENT real interest rate, being at a loss. If the inflation rate is lower than the expected THREE PERCENT, say TWO PERCENT, Luna would get SIX PERCENT real interest rate, being at an advantage.
Let’s generalize. In our world, Lin is the borrower, and Luna is the lender. If unexpected inflation occurs, the borrower will benefit. Conversely, if the actual inflation rate is lower than expected, the lender will benefit. Turns out, inflation might not be as bad of a thing as you might have thought!