Question

What is the Fisher Effect? Show and explain its causes and effects in both the bond and money markets. (draw graphs)

Answer 1

Fisher effect is an important tool in determining whether or not a lending is profitable.

This concept states the relationship between inflation and both real and nominal interest rates.

It states that real interest rate is the difference between nominal interest rate and expected inflation rate

Real interest rate = Nomonal interest rate - Expected inflation rate

It is an important tool used by lenders to evaluate whether or not they are lending profitably,.keeping in mind the inflation rate in the economy.The rate of interest charged by them to the borrower should be above the rate of inflation ,otherwise they are incurring losses while lending money.

#Fisher equation and causes and effects on bond market ----

* In bond market , the change in expected inflation rate is the prime cause of determining the demand and supply of bonds.

This way ,what will be the price of bond, is larhely depends upon the expected rate of inflation.

effect on bond market is visible in the diagram ,as rise in expected inflation,shifts the bond demand curve on the left side ( decreased demand) ,while shifting the supply curve rightward ( increased supply)..

DATE: EFFECT ON BOND PRICE DUE TO INFLATION TBS, PRICE OF BONDS Bd Bdi Quantity of BONDS • A RISE IN EXPECTED INFLATOA SHULETS THE Bend' DEMAND CURVE_LEFTWARS & Skues "THE SUPPLY CURVE._RIGHTWARD LT CAUSES THE PRICE OF BONDS TO FALL AND THE EQUILIBRUM INTEREST RATE TO RISE

At new equilibrium point ,we see, the new bond price p1 ,which is below original price P .It all happened due to expected inflation, considering the fisher equation effect.

# Money market and fisher effect------:

so above diagram , shows ,the cause of change in money market, which states that as quantity of money increases in circulation,price level also increase in equal proportion due to increase in aggregate demand.But on the other side ,value of money decreases.

MONEY MARKET & FISHER EFFECT PRICE LEVEL - n M M MONEY SUPPLY VALUE OF MONEY --------- 1/P= f(M) M M M MONEY supply

The reason behind ,is ,there is a direct relation between money supply and inflation rate.

Inflation rate affects the real rate of interest,because there is inverse relation between inflation and real interest rate.

This is the reason ,the govt increases money supply keeping in mind ,inflation to grow with eqvivalent rate.

Hope it will help you.