Question

Given the Fisher Equation, what is the impact of a zero nominal interest rates (we have approached very low rates recently—although not zero, it has been close) and deflation on the real interest rate. You need to write down the Fisher Equation along with this answer.

Answer 1

The Fisher Effect indicates the correlation between real interest rates, nominal rates and inflation rates. The actual interest rate is comparable to the nominal interest rate minus the expected inflation rate, as shown by the Fisher Effect (note that all rates used in this equation must be compounded). As inflation rates rise, real interest rates decrease if nominal rates are not increased at rates equal to inflation. This effect is not always evident immediately, but is increasingly visible over time.

EQUATION: r = i – π

i = Nominal Interest Rate

r = Real Interest Rate

π = Inflation Rate

It can be written as (1 + i) = (1 + r) (1 + π).

EXAMPLE: If inflation is 4 percent per year and the nominal interest rate is 10 percent, then next year every dollar in the bank will be $1.10. But because inflation is 4%, $1.10 can buy only 6% more goods and services (rather than 10%), making the real interest rate 6%. In this case, it is plugged into the above equation: 6%[ r]= 10%[ I]–4%[ π] r= 6% (real interest rate) I= 10% (nominal interest rate) π= 4% (inflation rate)

Nominal interest rates tend to run alongside inflationary rates to effectively neutralize monetary policy. In particular, when a central bank increases the monetary supply, and inflation is expected to increase, the central bank increases interest rates too. And if nominal interest rates rise at the same time as inflation, that means there is little practical impact.

A nominals zero or even a negative amount can therefore be established if the inflation rate is equal to or below the rate of interest of the loan or investment; a zero nominal interest rate is defined when the rate of interest is the same as the inflation rate-with inflation at 6%, then the rate of interest is at 6%.