Inflation is defined as a rise in the average level of prices for all goods and services.Some prices of individual goods and services are always rising,while others are declining.
However, inflation occurs when the average level of all prices in the economy rises.Interest rates represent the “price” of credit.
The Nominal and Real Interest Rate
To examine the relationship between inflation and interest rates, several key terms must be defined.First, we must distinguish between nominal and real interest rates.The nominal rate is the published or quoted interest rate on security or laon.In contrast, the real rate of interest is the return to the lender or investor measured in terms of its actual purchasing power.In period of inflation,of course,the real rate will be lower than the nominal rate.Another important concept is the inflation premium, which measures the rate inflation expected by investor in the marketplace during, the life of financial instrument.
These three concepts are all related to each other.Obviously,a lender of funds is most interested in the real rate of return on a loan.that is purchasing power of any interest earned.In general,lenders will attempt to charge nominal rates of interest which give them desired real rates of return on their loanable funds.And nominal interest rates will change as frequently as lenders alter their expectations regarding inflation.
The Fisher Effect
In a classic article written just before the turn of the century,economist living fisher argued that the nominal interest rate was related to the rate by the following equation:
Nominal interest rate=(Real rate)+(Inflation premium)+(Real rate×Inflation premium)
The cross-product term in this equation is normally ignored because it is usually quite small.
Fisher argues that the real rate of return tends to be stable over time because it depends on such long-run factors as the productivity of capital and the volume of saving in the economy.Therefore, a change in the inflation premium is likely to influence only the nominal interest rate.The nominal rate will rise as the expected rate of inflation increases, and decline with a drop in expected inflation.For example,the real rate is 3 percent and the drop rate of inflation is 10 percent.Example,suppose the real rate is 3 percent and the expected rate of inflation is 10 percent.Then the nominal rate will be calculated as follows
Nominal interest rate= 3%+10%=13
According to Fisher’s hypothesis, if the expected rate of inflation now rises to 12 percent,the real rate will remain unchanged at 3 percent, but the nominal rate will rise to 15 percent.
If this view is correct, it suggests a method of judging the direction of future interest rate changes.To the extent that rise in the actual rate of inflation causes investor to expect greater inflation, in the future, higher nominal may causes investors to revise downward their expectation of future inflation, leading to lower nominal interest rates.
Another view on Fisher effect
The Fisher effect conflicts with another view of the inflation-interest rate phenomenon,developed originally by the British economist Sir Roy Harrod.It is based upon the liquidity preference theory of interest, Harrod argues that the real rate will be affected by inflation,but the nominal rate is determined by the demand for and supply of money.Therefore ,unless inflation affects either the demand for and supply of money,the nominal rate must remain unchanged regardless of what happens to inflationary expectations.
In liquidity preference theory,the real rate measures the real rate of interest.In liquidity preference theory,the real measures the inflation adjusted return on bonds. However,conventional bonds,like money,are not a hedge against inflation,because their rate of return is fixed by contract.
However,conventional bonds,like money,are not a hedge against inflation,because their rate of return is fixed by contract.Therefore,a rise in the expected rate of inflation lowers investors’ real return from holding bonds..While the nominal rate of return on bonds remains unchanged,the real rate is squeezed by expectations of rising prices.
While theories of interest rate determination typically assume there is a single interest rate in the economy,in point of fact there are thousand of different interest rates confronting investors at any one time.The investors must focus upon several factors the maturity or term of a loan,the risk of borrower default,and inflationary expectations.