When it comes to inflation, the Fisher equation is a very important concept. It explains how the interest rates on loans can be different from the rates that people earn on their savings. This is because inflation can make prices go up, which affects the value of money.
The Fisher equation is an important calculation that might help your business stay relevant during times of high inflation. In this article, we'll explain what the Fisher equation is, how to calculate it, and provide some examples. So if you want to learn more about this essential economic concept, keep reading.
What is the Fisher Equation
The Fisher equation is a mathematical formula that shows the relationship between interest rates and inflation. It's named after economist Irving Fisher, who first published it. The Fisher equation is often used in circumstances where investors or lenders request an extra reward to compensate for losses in purchasing power caused by high inflation.
As we said, the Fisher equation is a relationship between interest rates and inflation. More specifically, it's the formula for the real interest rate. The real interest rate is the rate of return after taking inflation into account. In other words, it's the percentage of an investment's value that you can expect to keep after accounting for inflation.
The formula of the Fisher equation
The formula of the Fisher equation is
(1 + i) = (1 + r) (1 + π)
i = It is the nominal interest rate
r = It is the real interest rate
π = inflation rate
So, what does this formula mean? Let's break it down
The first part, (1 + i), is the nominal interest rate. This is the rate that's typically advertised by banks and other financial institutions. It's the rate before taking inflation into account.
The second part, (1 + r), is the real interest rate. This is the rate of return after taking inflation into account. In other words, it's the percentage of an investment's value that you can expect to keep after accounting for inflation.
And finally, the last part, (1 + π), is the inflation rate. To find the real interest rate, you have to account for how much prices are rising.
Example of the Fisher Equation
Now that we know what the Fisher equation is and how to use it, let's look at an example.
Imagine you're considering investing in a company. The company says that it will pay you a 5% return on your investment each year. However, you're worried about inflation. You know that the inflation rate is 3%. So, you use the Fisher equation to calculate the real interest rate.
Here's how you would do that
First, you would plug in the values for i (5%), r (3%), and π (5%). Then, you would solve for r
(1 + 5%) =(1 + r) (1 + 3%)
r = 2%
This means that the real interest rate is 2%. In other words, after accounting for inflation, you can expect to earn a 2% return on your investment each year.
Conclusion
The Fisher equation is an important concept in economics that explains the relationship between interest rates and inflation. It's a useful tool for businesses and investors who want to calculate the real interest rate during inflation. In this article, we explained what the Fisher equation is, how to calculate it, and provided an example. Thanks for reading.
Originally Published Here: Fisher Equation: Definition, Formula, Calculation, Example
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