Introduction to Banking and Financial Markets

Prof. P C Narayan

Week 2

Fisher Effect

In the earlier video, we have seen how changes in demand or supply of money causes
changes to the equilibrium interest rate. Interestingly, interest rates are impacted by
factors other than demand and supply of money.

Let’s say, there’s a set of toys you want to gift to a child, and the price of that set of
toys is, let us say, 100 currency units today. Now you have a choice. You could either
buy the toys and gift it to the child now, or postpone the purchase of the toys and gift
it to the child next year. The question is, under what circumstance would you buy
the set of toys today and gift it to the child, or postpone it for one year. The emotional
side of you obviously would say, “Buy the toys now and gift it to the child.” The
rational side of you would probably say, “No, let me see if I can delay this by a year.”
And that decision to delay is actually driven very rationally and, may I say, intuitively
by two very profound concepts in the world of economics and finance—interest rates
and inflation.

In the toy example, you have 100 currency in your hand today. If you gifted the toy
to the child today, you’re down 100 currency unit and the child gets the toys. On the
other hand, if you decide to gift the toy to the child next year, you have the
opportunity to put the money, say, in the bank. In which case, you will get a 108
currency units in the end of one year—eight percent the interest being paid by the
bank per annum. That means, you are in the money by 8 currency units.

Now the question is: by how much would the price of the toy have gone up in that
same one year? Fair to assume that it would have gone up by the extent of the
expected inflation in that country. Let’s put some numbers to this. Let’s say expected
inflation in that country is five percent. What that means is, a toy that cost a 100
currency units now, will sell for 105 currency units next year. And if you put your

© All Rights Reserved. This document has been authored by P C Narayan and is permitted for use only within the course Introduction to
Banking and Financial Markets delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
 Introduction to Banking and Financial Markets

Prof. P C Narayan

Week 2

money in the bank for the same one year, your 100 currency units would have grown
to a 108. Now simple arithmetic tells you, you can buy the toy a year from now, gift
it to the child, and you would have three currency units left in your pocket because
the interest rate was eight percent and the inflation rate was five percent.

Now this illustrates actually a very symbiotic relationship between interest rates and
inflation, which is exactly what Irving Fisher expounded in his Fisher Equation
several decades ago. What he said was, nominal interest rates is equal to real interest
rates plus expected inflation. The complete Fisher Equation is (1+In) = (1+Ir) *
(1+E(I)) Now if you expand that, it can be simplified as In is equal to Ir plus E(I).

Now, In represents nominal interest rates, which in our toy example, is eight percent.
Ir represents real interest rate, which in our toy example is three percent, and EI
represents expected inflation, which in our toy example is, five percent. Ir actually
represents the real price of money as we have learnt in the earlier video—mandated
by the economics of demand and supply. Higher the demand, lower the supply. Ir
would be higher and vice versa. Since Ir cannot be negative, higher inflation tends to
push up nominal interest rates. In no country in the world can the inflation rate be
higher than the nominal rate. If you can conceive of such a situation, every individual
in that country will become poorer by the year because, for example, money kept in
the bank would fetch you eight percent in the end of one year because nominal
interest rate is eight percent. But due to inflation, price of all items would have gone
up.

If, for example, the inflation rate is 11 percent, the price of all items would have
gone up by eleven percent. Remember your money has grown by eight percent. 100
became a 108. What was costing you 100 last year, is going to cost you 111 this
year.

© All Rights Reserved. This document has been authored by P C Narayan and is permitted for use only within the course Introduction to
Banking and Financial Markets delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.
 Introduction to Banking and Financial Markets

Prof. P C Narayan

Week 2

In other words, your purchasing power has actually gone down because the inflation
rates are higher than the nominal interest rate. In well-run economies, this will never
be allowed to happen. The governments in those countries, therefore, are always
under pressure to make sure inflation is kept as low as possible so that, as per the
Fisher Equation, interest rates will also remain as low as possible. And remember,
low interest rate is always a trigger to create a good investment climate in any
economy.

© All Rights Reserved. This document has been authored by P C Narayan and is permitted for use only within the course Introduction to
Banking and Financial Markets delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic,
mechanical, photocopying, recording or otherwise – without the prior permission of the author.