Money, Banking, and International Finance

market price is greater in the first case and lower in the second case. Therefore, changes in bond
prices and interest rates become ambiguous. Unfortunately, we cannot prove interest rates rise
during economic expansions and fall during recessions.

Figure 8. Both supply and demand functions increase

The Fisher Effect

We only discussed nominal interest rates. We did not adjust the nominal interest rates for
inflation. Unfortunately, inflation can have a significant influence on the financial markets.
Investors and savers are concerned about the real interest rate because the real interest rate
reflects the true cost of borrowing. The Fisher Effect relates nominal and real interest rates and
we define the notation as:

 i is the nominal interest rate.

 r equals the real interest rate.

 e is the expected inflation rate.

We show the Fisher Effect Equation in Equation 1. It equals a geometric average of the
expected inflation rate and real interest rate.

i+ 1 = 1 +r 1 + π e ( 1 )

For low inflation and low interest rates, we can use the approximation that we had derived

in Equation 2. We set the cross term r  e to zero because it becomes a tiny number. However, if