Q.2. Use the Fisher equation and prove that if we use following values and then double the
supply of money, what would be the impact on general price level and real value
(15)
M = 400
M 1 =200
V = 5
V 1 =2.5
T =50
Answers
Answer:
inflation.
Fisher Equation
The concept is widely used in the fields of finance and economics. It is frequently used in calculating returns on investments or in predicting the behavior of nominal and real interest rates. One example is when an investor wants to determine the actual (real) interest rate earned on an investment after accounting for the effect of inflation.
One particular significance of the Fisher equation is related to monetary policy. The equation reveals that monetary policy moves inflation and the nominal interest rate together in the same direction. On the other hand, monetary policy generally does not affect the real interest rate.
American economist Irving Fisher proposed the equation.
Fisher Equation Formula
The Fisher equation is expressed through the following formula:
(1 + i) = (1 + r) (1 + π)
Where:
i – the nominal interest rate
r – the real interest rate
π – the inflation rate
However, one can also use the approximate version of the previous formula:
i ≈ r + π
Fisher Equation Example
Suppose Sam owns an investment portfolio. Last year, the portfolio earned a return of 3.25%. However, last year’s inflation rate was around 2%. Sam wants to determine the real return he earned from his portfolio. In order to find the real rate of return, we use the Fisher equation. The equation states that:
(1 + i) = (1 + r) (1 + π)
We can rearrange the equation to find real interest rate:
Real Interest Rate - Formula
Therefore, the real interest rate, or actual return on investment, of the portfolio equals:
Real Interest Rate - Solution
The real interest that Sam’s investment portfolio earned last year, after accounting for inflation, is 1.26%.
Related Readings
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Effective Annual Interest Rate
Floating Interest Rate
Market Risk Premium
Normative Economics
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