What does the Fisher Effect describe?

The Fisher Effect describes the relationship between real and nominal interest rates, specifically illustrating how changes in expected inflation rates influence nominal interest rates. According to the Fisher Effect, if consumers expect higher inflation in the future, nominal interest rates will rise to compensate lenders for the decrease in purchasing power of money over time. This means that the nominal interest rate is composed of the real interest rate plus the expected inflation rate.

Understanding this relationship is crucial for finance managers as it helps them make informed decisions about investment, borrowing, and setting interest rates. It emphasizes that while nominal rates can fluctuate due to inflation expectations, the real interest rate remains the effective rate that reflects the true cost of borrowing when adjusted for inflation.