In economics, the Fisher effect is basically the trend for fixed interest rates to fluctuate to match the initial inflation rate. It is also known as the Taylor rule after the famous economic thinker, Irving Fisher. The concept of the Fisher effect was developed by a Chicago businessman, Sam W. Fisher, in 1928. His notion that government should intervene in the business cycle to offset excess monetary demand created by excess capacity created by the reduction of aggregate demand in the economy.
The concept of the Fisher effect can be described as the attempt of the central bank to offset the effects of changes in the short term interest rate with changes in the long term rate of interest, with an aim to control the fluctuations in the prices of essential goods. This is done by changing the nominal interest rate so as to control the upward pressure on the price of desired assets (in this case, inflation) and so as to control the downward pressure on the price of desired commodities (in this case, deflation). A general increase in the level of nominal interest rate, for instance, may put an upward pressure on market returns. This can either be beneficial to the creditors of lenders or adverse to the borrowers of loans.
However, this is not the only way in which changes in the nominal rates affect international trade. Changes in the rate of exchange rates between two countries can also have an effect on the inter-linkage processes between the currencies of two countries. The term “fisher-effect” was first used to describe this phenomenon in international trade. It was noted by Sir Henry Ford in his book “The New Industrial Revolution”, “The tendency to increase the manufacturing of certain articles leads to a corresponding rise in the demand for other goods.” According to Fisher, it is the tendency of a country’s nominal rate of interest to rise along with the demand for that rate of interest.
The basic intuition behind the fisher effect is that increases in the monetary policy rates will tend to lead to increased production and employment. But this intuition is not consistent with all aspects of monetary policy. For example, it is argued that because unemployment is a major constraint on increased investment, rises in interest rates do not lead to increased employment. They may only lead to a temporary increase in the demand for labor. This is illustrated by the fact that while falling unemployment rates tend to reduce the real effective rate of interest, it tends to increase the price of imported goods.
However, another aspect that is often ignored is the impact of the inflation rate on the purchasing power of the national currency. The Fisher effect can be best illustrated by looking at how changes in the price level of input goods have impacted the changes in the price level of output goods. For instance, when the price level of oil is increasing, the potential demand for energy is also increasing and consequently, the purchase power of the dollar drops. Similarly, when there is an increase in the inflation rate, it is expected that the domestic price level will also rise, but then consumers will shift from buying power based on the rising inflation to buying power based on the falling domestic price level.
To better understand this concept, let us consider an alternative scenario. In this scenario, let us assume that the Federal funds rate rises in response to the rise in inflation. This leads to higher inflation in the United States until the cycle is broken and the fed funds rate starts to fall again. The conclusion is that in this case, the changes in market returns do not reflect changes in the purchasing power of the dollar. Rather, the changes are driven by changes in the balance of payments between the federal funds rate and the national interest rate.
It is important to take note that this does not mean that the existence or absence of the Federal funds rate will not have a significant impact on the observed trends in the real interest rate or the nominal interest rate. For instance, if the expected inflation rate is 3%, then we can safely say that a rise in the monetary measures will have a significant impact on the expected real interest rate. However, the effect of the Federal funds rate on the expected real interest rate depends upon the current state of the economy in the United States. In this regard, the recent drop in oil prices has had a significant impact on the expected real interest rate. In addition, some of the recent indicators from some of the major economic indicators such as the FOMC rate expectations, G7 inflation expectations, and Treasury bond market rates imply that inflation may continue to rise in the future.
When it comes to the discussion of the fisher effect in the context of monetary policy, most forecasters still expect that the effects of the inflation will be most visible in the period just ahead. Accordingly, there is a great deal of skepticism regarding the effectiveness of the policies adopted by the Federal Reserve to control inflation in the long run. In fact, even those who are in favor of stricter monetary measures to control inflation have not been successful in achieving this goal so far. Even though the inflation is controlled to a certain extent, the rapid increase of the price of commodities such as oil, crude gas, silver, gold, and other precious metals is hardly surprising. The inflationary pressure is still there, and the effects of the tightening of monetary policy, which are expected to last for the coming years, will only add to the problems facing the global economy.