The Fisher Effect and the Quantity Theory of Money

The Fisher Effect and the Quantity Theory of Money

Eric Mahaney

4/7/13

EC-301-1

The Fisher effect and the Fisher equation were made famous by economist Irving Fisher. He created his equation by rearranging the equation for real interest rate, which is (r = i - π). Real interest rate equals the nominal interest rate plus inflation. This is a very basic equation. Fisher manipulated it to solve for i, in order to understand the effect that inflation has on nominal interest rate. The famous equation is i = r + π, nominal interest rate equals real interest rate plus inflation. This is basically saying that the nominal interest rate can be changed by a change in either the real interest rate or inflation. The Fisher effect is the one to one relationship between the inflation rate and the nominal interest rate. According to this model, as inflation increases, the nominal interest rate should also increase by the same proportion. The main concept behind the Fisher effect is that higher inflation causes higher nominal interest rate. (Mankiw, 91-92)

By using the Fisher effect along with the quantity theory of money, the effect that money growth has on nominal interest rate can also be analyzed. The quantity theory of money is M*V=P*Y or the quantity of money multiplied by the velocity of money equals price multiplied by output. The velocity of money is assumed to remain constant in order to simplify the model. Therefore, PY is determined solely by the quantity of money. PY represents nominal GDP because prices times output is nominal GDP. Y is determined by the factors of production and the production function. Y is also used as real GDP. Because Y is considered exogenous and already determined by the production function and the factors of production, so a change in the quantity of money will affect only the price level and is therefore directly proportional. In other words, an increase in the money growth results in an equal growth of the price. An increase in prices is called inflation. According to the quantity theory of money, an increase in the money supply results in an equal growth of the inflation rate. This increase in the inflation rate in theory causes an equal increase in nominal interest rate. (Mankiw, 82-87)

The fisher equation undergoes further manipulation to account for the lag time between the time that the nominal interest rates are set and the inflation that occurs during that time and the time that the interest rate is realized. Because the inflation rate is unknown at time onset of the interest rate the expected inflation rate is used in its place. The ex ante real interest rate is the real interest rate based on the expected inflation. The real interest rate that is realized at the maturity