The Fisher Equation

The economist Irving Fisher proposed a very simple equation that is known as the Fisher Equation, and that relates the nominal and real interest rates. A simple equation would say that the nominal interest rate is the real interest rate plus the expected inflation rate. This relation is very important to borrowers because while all the contracts specify a nominal interest rate, its end is to reach a specific interest rate, even after a subsequent inflation reduces the value of money. By using the Fisher equation, lenders and borrowers can determine what nominal interest rate to use to achieve a real given rate, keep in mind the expected inflation rate.

To see how this works, suppose that a moneylender and a money borrower agree that a six percent is a real and reasonable interest rate and that it is probable that the inflation rate will be of 3,3 percent during one year. By using the Fisher equation, they redact the loan contract with a nominal interest rate of 9,3 percent. One year later, when the money borrower pays the money lender back 9,3 percent over what was received, it is hoped that that money only have six percent more buying power than the money borrowed, given the expected increase on the prices.

Predictions Are Not Always Correct
There are a lot of economists whose description of functions consists, most of all, on trying to predict the future inflation rates. Their predictions have a good amount of diffusion in the specialized media in business, but each one presents their own prediction of the inflation. Some people follow the advice of the experts, while there are others that do their own estimates based on their everyday experiences. Keep in mind however, that since predictions are not one hundred percent exacts, nobody is really sure or can be sure of what the real return rate over the loan will be.

Beginner Money Investing Putting a Price on the Future The Fisher Equation