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The Fisher effect states that the real interest rate is stable and that changes in the nominal interest rate result from expected inflation. It can be expressed using the following equation:
Nominal Interest Rate = Real Interest Rate + Expected Inflation
Fisher effect implies that the nominal interest rate quoted on the financial asset has embedded inflation expectations. If inflation changes, the nominal interest rate must also change in line with the concept of money neutrality.
Further, the nominal interest rate also includes a risk premium, which is compensation for the uncertainty inherent in the real interest rate and expected inflation.
According to the Fisher effect, changes in nominal interest rate results from:
A) Changes in the real interest rate
B) Changes in expected inflation
B is correct. Fisher effect assumes that the real interest rate is stable and that changes in nominal interest rate result from changes in expected inflation.
by Obaidullah Jan, ACA, CFA on Tue Feb 11 2020
This article can help you prepare for Reading 16 LOSe.