The Fisher Effect says that nominal interest rates change to reflect expected inflation (Mankiw, 2026). To analyze the Fisher Effect, you must consider three things – the real interest rate, the nominal interest rate, and expected inflation. The real interest rate is how much your money actually grows. The nominal interest rate is the rate you see or are quoted for a loan. It does not take into account inflation or loss of buying power due to inflation. Finally, expected inflation is what people think inflation will be in the future or their best guess about future price increases.
What it Means
- If expected inflation rises, lenders demand higher interest rates
- As a result, nominal interest rates increase
- The real interest rate stays roughly the same (in the long run)
Example:
Situation 1: Lower expected inflation
Real interest rate () = 3%
Expected inflation () = 2%
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Nominal Interest rate () = 3% + 2% = 5%
Situation 2: Higher expected inflation
Real interest rate () = 3%
Expected inflation () = 4%
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Nominal Interest rate () = 3% + 4% = 7%
Why it Matters
- Helps explain why interest rates are higher in high-inflation periods
- Shows how lender protect their purchasing power
Mankiw, N. G. (2024). Principles of Economics. Cengage Learning.
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