Kenneth R. Szulczyk

the inflation rate or interest rate becomes high, then the approximation loses accuracy as the
cross term becomes large.

    

e

e e

e

i r+ π

i r r

i+ = +r + π



 1  1     

1 1 1

( 2 )

For example, you expect the inflation rate will be zero ( e = 0 ), and you grant a loan for
5% for one year. At the end of Year 1, you have 5% more money in real terms because you can
purchase 5% more in goods and services. We calculated the real interest rate in Equation 3.

ri π e 5  0 = 5 ( 3 )

What would happen if you believe inflation will increase to 5% ( e = 5% ), and you grant a
loan for one year at 5%? At the end of year 1, you would have 5% more money, but prices,
unfortunately, became 5% greater too. Consequently, your purchasing power would not change
in real terms. We calculated the real interest rate in Equation 4.

ri π e 5  5 = 0 ( 4 )

Real interest rate, therefore, reflects the true cost of borrowing and becomes a better
indicator of incentives to lend and borrow. Many financial analysts use nominal interest rates
because inflation is low in the United States, averaging 3% per year or less.
We can use the bond market to show the Fisher Effect. If the investors and businesses
expect higher inflation in the future, then investors buy fewer bonds while businesses sell more
bonds. Investors know the inflation would erode the value from their investment while
businesses could repay the bonds with inflated dollars. Consequently, the demand for bonds
shifts toward the left while the supply for bonds shifts rightward. We show the impact on the
bond market in Figure 9. Accordingly, the price of bonds decreases and the interest rates
increases. In this case, the amount of bonds (Q*) in the market is ambiguous. You prove this by
shifting the demand and supply curve enough, so the quantity does not change. Then shift either
function a little more and the equilibrium quantity changes direction. Thus, the greater
inflationary expectations cause greater bonds prices and lower bond interest rates as we discount
bond prices.
Financial analysts always write interest rates for financial instruments in nominal terms. If
investors and the public have higher expectations of inflations ( e ), then nominal interest rates
(i) become greater. If the government wants low nominal interest rates, then the public and
investors must believe the inflation rate will be low.