L7_IRP2 - The Fisher Effect Irving Fisher (1930): Real...

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1 1 Lecture 7: IFP and FRUC The Fisher Effect Irving Fisher (1930): Real interest rates are stable over time. Inflationary expectations cause fluctuations in nominal interest rates. If expectations for future inflation change, the nominal interest rates will also change so that real interest rates remain stable. 2 Lecture 7: IFP and FRUC The Fisher Effect Example: Invest $1 in a real asset (one apple tree): return is liquidated for $1(1+ r )[1+ E ( p )], where r is the real interest rate and E ( p ) is the expected rate of inflation. Invest $1 in a nominal asset: return is liquidated for $1(1+ i ), where i is the nominal interest rate.
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2 3 Lecture 7: IFP and FRUC The Fisher Effect To be indifferent, the real and nominal assets should offer the same return, i.e., (1+ i ) = (1+ r ) [1+ E ( p )] i = r + E ( p ) + rE ( p ) Where inflation and the real interest rate are low, the Fisher effect is usually approximated as: i = r + E ( p ) % nominal interest rate % real interest rate % expected inflation = + 4 Lecture 7: IFP and FRUC The Fisher Effect Parity between “real” investment and nominal investment: E(p) = expected rate of inflation r = real rate of interest i = nominal rate of interest Fisher effect: i = r + E(p) When the realized inflation rate is different from the expected rate, there is a redistribution effect between borrowers and lenders.
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3 5 Lecture 7: IFP and FRUC Example of the Fisher Effect A lender wants a 4% real interest rate in his loan and expects a 3% inflation. The nominal rate he should charge is 4% + 3% = 7%. If the realized inflation is 5%, the lender suffers and the borrower gains. The real interest rate is only 2%. If the realized inflation is 2%, the lender suffers and the borrower suffers. The real interest rate is 5%. 6 Lecture 7: IFP and FRUC Arbitrage to the Fisher Parity Individuals move out of financial assets into commodities when inflation is high but not fully reflected in nominal terms. The nominal rate goes up. When nominal rates are high relative to inflation rates, individuals would prefer financial assets to lock in high returns. The nominal rate goes down.
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4 7 Lecture 7: IFP and FRUC International Fisher Effect Expected return from investing $1 in US market: $1 (1 + i $ ) Expected return from investing $1 in German market: $1 (1 / S $/ ) (1 + i ) E(S $/ ), where E(S $/ ) is the expected future spot rate By arbitrage: (1 / S $/ ) (1 + i ) E(S $/ ) = (1 + i $ ) Rearrange terms and subtract 1 …. 8 Lecture 7: IFP and FRUC International Fisher Effect Note: almost identical to covered interest rate parity condition except includes E(S $/€ ) rather than the forward rate E(S $/€ ) - S $/€ (i $ -i ) = S $/€ (1 + i ) % change in the % interest rate expected spot rate differential
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5 9 Lecture 7: IFP and FRUC Uncovered Interest Rate Parity A deviation from CIR is uncovered interest
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This note was uploaded on 04/12/2008 for the course ECON 442 taught by Professor Chari during the Winter '08 term at University of Michigan.

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L7_IRP2 - The Fisher Effect Irving Fisher (1930): Real...

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