The Fisher equation tells us that the real interest rate approximately equals the nominal rate minus the inflation rate. Suppose the inflation rate increases from 3% to 5%. Does the Fisher equation imply that this increase will result in a fall in the real rate of interest

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The Fisher equation tells us that the real interest rate approximately equals the nominal rate minus the inflation rate. Suppose the inflation rate increases from 3% to 5%. Does the Fisher equation imply that this increase will result in a fall in the real rate of interest

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EWOMAZINOADEGO EWOMAZINOADEGO · Answer 1

The Fisher equation does not imply that the increase in inflation will result in a fall in the real rate of interest.

The Fisher equation states the nominal interest rate in the sum of inflation rate and the real interest rate

(1 + nominal interest rate) = (1 + real interest rate) x (1 + inflation rate)

Based on the above equation, an increase in inflation rate would lead to a rise in the nominal interest rate. The real interest rate is taken as given in the equation and it is not affected by changes in inflation rate. If inflation rate increases from 3% to 5%, the nominal rate of interest would increase by about 2%.

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