Fisher Effect

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The Fisher Effect describes how inflation impacts the real interest rate; inflation makes each unit of currency less valuable over time, which reduces the value of interest payments in the future.

Real Interest Rate = Nominal Interest Rate - Expected Inflation

The real interest rate accounts for inflation, whereas the nominal interest does not. In that sense, the Fisher Effect describes the relationship between inflation and real interest rates.

Inflation is caused by increases in the money supply, a rise in demand, or a supply shortage. Inflation will cause the future cash flows of an interest payment to become less valuable. In an inflationary environmnet, the real interest rate is always lower than the nominal interest rate. Accordingly, the real interest rate is considered a more accurate representation of interest rates because it accounts for the decline in value of currency.

Learn more about how inflation impacts the economy.