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October 14, 2002
Fisher theory of interest rates
The Fisher theory states
(1+nr) = (1+i)(1+r)
The nominal interest rate is propotional to the product of inflation and the real interest rate. Interest rate is the 'rental' price of money. If you rent a sofa you pay for the use of the sofa. The sofa undergoes wear and tear and reduction in value due to passage of time. The rental rate usually takes this into account. When you rent money there is no wear and tear but there is a reduction in value due to inflation. Therefore the interest rate takes inflation into account. The standard way to look at real interest rate is to look at it as the increase in consumption. I will give you $100 today if that means I will get $105 next week. This means the real interest rate is 5% per week. However if inflation is running at 2% per week then I need to factor that in. This is what the Fisher theory solves. The nominal interest rate (the rate I charge you) is a combination of my real interest rate (5%) and the inflation (2%). Hence
nr = (1+.05)(1+.02)-1 = 7.1%
What else did Fisher say?
Quantity Theory of Money
MV = PT
M = money
V = velocity
P = prices
T = level of transactions
Essentially means that as money supply increases prices will increase as well implying expanding the money supply causes inflation. This is the basis for the Fed increasing interest rates to combat inflation in the 80's.
Lot more info at the history of economic thought
Posted at October 14, 2002 10:17 AM