What is the Fisher Effect?

Patrick Roland

Interest rates and inflation are objects of financial fascination around the world. The Fisher effect is a theory about the relationship between the two, basically stating that when one rises, so does the other. The theory exclusively refers to domestic rates, but there is a related theory about the relationship of interest and inflation on an international scale. This hypothesis has been utilized by economics experts for many years, but there still are some who do not believe in its relevancy.

Man with hands on his hips
Man with hands on his hips

Irving Fisher was an economist in the United States who graduated from Yale University in 1888 and died in 1947 at age 80. He became one of the best-known economic minds of his time because of his Fisher effect theory and for his debt deflation theory. His neoclassical economic ideas have been taught in economics classes around the world.

Fisher's famous hypothesis, the Fisher effect, deals directly with the relationship between interest rates and inflation. In Fisher's eyes, the two are tethered together by a variety of economic demands. The relationship is so strong that if inflation rises, the interest rate will rise an equal amount.

The Fisher effect frequently is utilized by businesses to understand the actual, or nominal rate, of interest. One example of this would be to consider a country's rising inflation rate. If a nation's inflation rate increases by 1 percent, the Fisher effect states that the interest rate also will rise by 1 percent.

A slightly enhanced version of the Fisher effect allows for economists to compare two nations' currencies based on interest rates. The International Fisher effect states that the difference between two countries' interest rates will directly effect the exchange rate between those two currencies. In this hypothesis, the value of the currency with the lower nominal interest rate will increase because of the other country's higher rate.

The Fisher effect remains a theory and not a proven fact. Many economists completely denounce Fisher's thoughts on the relationship between interest and inflation. Many economists claim that the interest and inflation rates are independent of one another and altogether unpredictable because of the incredible amount of factors involved, such as the job market, currency trading, imports and exports. This, too, is a theory and, like Fisher's theory, is an attempt at making predictions about financial fluctuation.

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