What it is:
The Fisher Effect is an economic hypothesis stating that the real interest rate is equal to the nominal rate minus the expected rate of inflation.
How it works (Example):
In the late 1930s, U.S. economist Irving Fisher wrote a paper which posited that a country's interest rate level rises and falls in direct relation to its inflation rates. Fisher mathematically expressed this theory in the following way:
R Nominal = R Real + R Inflation
The equation states that a country's current (nominal) interest rate is equal to a real interest rate adjusted for the rate of inflation. In this sense, Fisher conceived of interest rates, as the prices of lending, being adjusted for inflation in the same manner that prices of goods and services are adjusted for inflation. For instance, if a country's nominal interest rate is six percent and its inflation rate is two percent, the country's real interest rate is four percent (6% - 2% = 4%).
Why it Matters:
The Fisher effect is an important tool by which lenders can gauge whether or not they are making money on a granted loan. Unless the rate charged is above and beyond the economy's inflation rate, a lender will not profit from the interest. Moreover, according to Fisher's theory, even if a loan is granted at no interest, a lending party would need to charge at least the inflation rate in order to retain purchasing power upon repayment.