Inflation & Interest Rate

Two Interest Rates: Real and Nominal

The interest rate that the bank pays is called the nominal interest rate, and the increase in your purchasing power is called the real interest rate. If i denotes the nominal interest rate, r the real interest rate, and p the rate of inflation, then the relationship among these three variables can be written as:

r = i − p

The Fisher Effect – (Irving Fisher (1867–1947)):

The Fisher effect shows that the nominal interest rate can change for two reasons:

  1. because the real interest rate changes or,
  2. because the inflation rate changes.

Rearranging terms in our equation for the real interest rate, we can show that the nominal interest rate is the sum of the real interest rate and the inflation rate:

i = r + p

According to the quantity theory, an increase in the rate of money growth of 1 percent causes a 1 percent increase in the rate of inflation. According to the Fisher equation, a 1 percent increase in the rate of inflation in turn causes a 1 percent increase in the nominal interest rate.

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