Q:

What is the Fisher effect formula?

A:

The Fisher effect formula calculates the real interest rate as the nominal interest rate minus the inflation rate. This number compares the amount one really earns in interest after factoring in the rising prices of goods.

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The nominal interest rate is the rate that the bank or other institution agrees to pay. The inflation rate is the percentage of increase in the cost of goods. If a person has money in the bank earning 5 percent interest, but the inflation rate is 4 percent, the real interest rate is only 1 percent. If, however, the nominal interest rate is 2 percent but the inflation rate is 3 percent, the real interest rate is -1 percent. If the person has \$100 in the bank and earns 2 percent interest, he has \$102. Figuring in the inflation rate, however, he loses \$3. In reality, he ends up with \$99, less than the sum with which he started.

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