Fisher hypothesis

In economics, the Fisher hypothesis (sometimes Fisher parity) is the proposition by Irving Fisher that the real interest rate is independent of monetary measures, especially the nominal interest rate. The Fisher equation is

r_r = r_n − π^e.

This means, the real interest rate (r_r) equals the nominal interest rate (r_n) minus expected rate of inflation (π^e). Here all the rates are continuously compounded. For simple rates, the Fisher equation takes form of

$1+i =(1+\rho )\times E(1+\pi)$

If r_r is assumed to be constant, r_n must rise when π^e rises. Fisher Effect: The one for one adjustment of the nominal interest rate to the expected inflation rate.

To understand the relationship between money, inflation and interest rates it is important to understand nominal interest rate and real interest rate. The nominal interest rate is the interest rate you hear about at your bank. If you have a savings account, for instance, the nominal interest rate tells you how fast the number of dollars in your account will rise over time. The real interest rate corrects the nominal rate for the effect of inflation in order to tell you how fast the purchasing power of your savings account will rise over time. An easy estimation of the real interest rate is the nominal interest rate minus the expected inflation rate (Note that this estimate is unwise when looking at compounded savings.)

Real interest rate = Nominal Interest Rate - Expected Inflation Rate

Nominal Interest Rate = Real interest Rate + Expected Inflation Rate

If inflation permanently rises from a constant level, let's say 4%/yr., to a constant level, say 8%/yr., that currency's interest rate would eventually catch up with the higher inflation, rising by 4 points a year from their initial level. These changes leave the real return on that currency unchanged. The Fisher Effect is an evidence that in the long-run, purely monetary developments will have no effect on that country's relative prices.

It has been contended that the Fisher hypothesis may break down in times of both quantitative easing and financial sector recapitalisation. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=521402

See also

The International Fisher Effect predicts an international exchange rate drift independent of inflation - that is, entirely based on the respective national nominal interest rates. (Though differential real rates will give the same exchange rate drift if inflation is internationally harmonized.)