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What is Fisher Equation and how to use it in Finance?

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You are probably trying to understand the concept of Fisher equation. Through this blog article you will have a clear idea about what is Fisher’s equation, how Fisher’s equation is used and Pros and Cons of Fishers’ equation. It is widely used concept that reflects a concept in economic which describe the relationship between real and nominal interest rate under the circumstances such as inflation. The equation implies that the nominal interest rate is equal to the total sum of the real interest rate plus the total inflation. This specific equation is often used in several situation, one such is when lenders or investors ask for additional reward to reimbursement for losses in buying power due to high inflation. This method now successfully deal with the statistical analysis of international trading of currencies and money supply.

What is Fisher Equation?

Fisher equation is named after its creator Irving Fisher, An American Economist, who was quite renowned for his works on the theory of interest. In the stream of finance, the fisher equation is mainly used in “yield to maturity” calculations of bond or “The internal rate of return” calculation of total investment. This is one of the main reason the Fisher equation continuously gained popularity in the market due to its unmatched concept and precise calculation in the theory of interest. This blog tries to explores several elements of the equation with examples, along with how to use the same equation in finance and its pros and cons.

The Author Andrew Stephani is a financial analyst at Bendigo Bank and writes finance assignment for students at Myassignmenthelperonline.com.

How does one calculate the fisher effect?

Fisher effect describes the relationship between both real and nominal interest rate and inflation. On contrary to fisher equation, the fisher effect states the real interest rate is same as that of nominal interest rate minus the expected interest rate. Therefore, real interest rates reduces as inflation increases, unless the expected nominal rate increases at the same rate as that of inflation.

The fisher equation formula to justify the relation between real interest and nominal interest rate can be given as follows:

(1+i)= (1+r)(1+π)

Where

r- The real interest rate

i- the nominal interest rate

π – the inflation rate

However, one cal also use the simplified version of the same equation:

                           i ≈ r + π 

Terminology-Nominal interest rate, inflation rate and real interest rate

Nominal interest rate depicts the financial return an investor would get when he deposit/invest money. For instance, a nominal interest rate of 10% per annum means that investors will receive an additional 10% of the total amount for his invested/deposited money in the bank. Unlike the nominal interest rate, the real interest rate considers purchasing power in the fisher equation.

In the fisher effect, the nominal interest rate is provided with actual interest rate which reflects its monetary growth padded over time to a certain amount of currency or money owned by a financer. Real interest rate is the total amount of purchasing power of the lent money as it grows over a period of time.

The inflation rate is an evaluation of the price inflation with comparison to annual percentage change in the CPI (consumer price index). Thus, the total inflation rate has its share in the development of the economy as it compares the rise in the general price level of goods. It is critical for any economy to monitor the inflation rate as an independent inflation rate can severely damage an economy. Moreover, excessive growth in the liquidity can often lead to high rates of inflation which can further push the economy to Hyperinflation.

An example of Fisher Equation

To completely understand how does Fisher equation work, one can refer to one instance, each time you go to the bank: the total interest rate, an investor/banker have on his saving account is generally nominal interest rate, for suppose if the nominal interest rate on a particular bond is 5% and expected rate of inflation is 3%, then the real interest rate will be 2%. Which implies that money invested in that particular bond is increasing by 2%. The smaller the interest rate, the longer it will take for the invested money to grow substantially in context with the purchasing power perspective.

Fisher equation

Significance of the Fisher effect in finance

The fisher effect is more than just an equation: it depicts how the money supply and investment affects the inflation and nominal interest rate as a tandem. For instance, if a change in the central bank’s monetary policy would push the country’s total inflation rate to rise by 10%, then the nominal interest rate of the same economy would follow the same suite and increase by 10% as well. In finance, one can use the mechanism of fisher equation to calculate the returns for the investment, let’s discuss it in more detailed view:

Short term application of Fisher equation

The fisher equation has short term practical application which anyone can use it in everyday life. Because it can calculate the expected figure of purchase power according to ongoing rates of inflation, you can use it describe the “real” return of the total investment in the context of what profits will buy. For instance, if you buy a 12-months bonds of deposit of $10,000 at an interest rate of 0.94%, with a constant inflation, then you will have the total amount of $10,094 at the end of year.

However, if the inflation increased by almost 2% then you will lose some money on the investment, as your purchasing power of the money and profit decreased by $106.99 or by almost 1.06%, getting to the total amount of $9987.01 at the end of the year.

By fisher equation

2.0-0.94=1.06
10096*1.06=106.99
10096-106.99=9987.01

Long term Significance of Fisher effect

Discovering the real rate of interest is important for making good investment decisions. While applying the fisher equation to find out the total return is both interesting and useful, results are even more significant when you use the fisher equation to find out returns in the long term. Usually, nominal interest rates don’t suddenly jump when there is a change in inflation, generally because a number of loans have fixed nominal interest rate, and these rates are already based on the expected level of inflation. Although if there is an unexpected change in the inflation, real rates of interest can drop in the short run as nominal interest rate are fixed to some degree.

Compound calculation using initial investment amount, nominal interest rate, time frame for investing and varying several rates of inflation can be a productive tool for analyzing and summarising the potential of an investment and it can also help you find out at what point in an economic cycle it is perfect to sell your share for maximum profits.

Pros and cons of using Fisher Equation

Fisher effect has its own set of pros and cons to calculate the total profit/return on the investment which are described below:

Pros of the Fisher Effect

  • Fisher effect distinguish between real interest rate and nominal interest rare giving the investor a clear picture for these interest rates
  • It eventually contributes to the sustainable development of any economy as it detects a situation where lenders or investors ask for an additional reward.

Cons of the Fisher effect

  • Liquidity Trap: The fisher equation works on the concept of minimizing nominal interest rates to influence the total expenditure in favour of the business. So to attract the investors to invest, the bank tries to increase the interest rate and eliminate all the chances for a higher inflation.
  • The elasticity of demand to interest rate: With the frequent rise in the total cost of the high-interest rates and assets to be worthless in minimizing demand. This gives the central banks the chance to increase the real interest rate to take effect.

The international Fisher effect (IFE)

The IFE or international fisher effect is an exchange-rate modal which extends the standard fisher effect and is used widely in forex analysis and trading. it is based on future and present risk-free nominal interest rate rather than pure inflations and it is used to forecast and understand the ongoing and future spot currency movements. For this modal to work precisely, it is assumed that the risk-free aspects of total capital must be allowed to freely float between the nations which comprise a certain currency pair.

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