Money, Banking & Finance Essay Example | Topics and Well Written Essays - 2000 words

The Fisher Theory of Nominal Interest Rates and Inflation Rate - Essay Example According to the economist, interest is ‘an index of a community’s preference for a dollar of a present (income) over a dollar of future income’ (Library of Economics and Liberty, 2008). The label that he has put to his theory of interest rate is ‘the impatience and opportunity’. Fisher has postulated in this theory that interest rate results from an interface between two forces: the time preference that people have for capital at present and the principle of investment opportunity (Library of Economics and Liberty, 2008). Irving Fisher’s theory of interest establishes a link of nominal interest rate (i) to the rate of inflation (П) and the real rate of interest (r). The rate which is derived after making an adjustment for the inflation is the real interest rate. This is the interest rate which the lenders should consider for lending their funds. The relationship that has been presented by Fisher between these three interest rates is: Thus, the above relationship states that if the rate of inflation increases by 1 percent, then the nominal interest rate increases by more than 1 percent. This means that there is a positive relationship between the rate of inflation and nominal interest rate (University of Missouri-Kansas City, 2010). In the next step of the analysis, the effect of taxes on the real rate of return will be taken into account. Let a country be considered with currency C. Then let it be the nominal risk-free rate of interest, rc be the real interest rate and Пc be the expected rate of inflation. Let to be the rate of tax on the interest income and r*c be the after-tax real rate of return. The after-tax rate of return is ic (1-to). Then, From the above expression, it can be explained that with the increase in the rate of inflation, the nominal interest rate also increases by a few proportion of the increase in inflation rate (Mulligan, 2002).  Ã‚